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# "NPV Decision Rule"

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Fishy Business is a designer and manufacturer of fishing equipment, is contemplating a \$300,000 investment into a new production facility. The economic life of the facility is estimated to be five years, after which the facility will be obsolete and have no salvage value.
To make the new facility operational, building improvements costing \$50,000 will be required. In addition, a \$25,000 increase in working capital will be needed.
Fishy Business' accounting and marketing departments have provided the following information: the firm will use straight line depreciation; the Company is in the 30% tax bracket; the weighted average cost of capital is 8%.
Here are estimates for EBDT for the new facility" Year 1: \$70,000; Year 2: \$95,000; Year 3: \$95,000; Year 4: \$80,000; Year 5: \$75,000.
Diagram the cash flows for the project using a time line. For each of Years 1 through 5, include the following data on your diagram (in this order): EBIT, tax, depreciation, Operating Cash Flow (OCF), and discounted OCF.
(1) Indicate the initial investment cost, the present value, the Net Present Value (NPV), and the payback (measured in years based on non-discounted OCF numbers).
(2) Evaluate the project's efficacy. Is this facility worthwhile, based upon your calculations ? Why or why not ? What does the "NPV Decision Rule" indicate for the facility ?

#### Solution Preview

Fishy Business is a designer and manufacturer of fishing equipment, is contemplating a \$300,000 investment into a new production facility. The economic life of the facility is estimated to be five years, after which the facility will be obsolete and have no salvage value.
To make the new facility operational, building improvements costing \$50,000 ...

#### Solution Summary

Response provides steps to compute the "NPV Decision Rule"

\$2.19
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## Discuss NPV decision rule; calculate payback period, IRR, profitability index

1) Your author offers four alternatives to the NPV rule. List and discuss these four alternatives.

2) When two mutually exclusive projects give conflicting acceptance indicators, how should the manager resolve the conflict?

3) Two projects have the expected cash flows shown below. The projects have similar risk characteristics and their cost of capital is 6 percent.

End of Year Project A Project B
Now (10,000,000) (8,000,000)
1 7,000,000 3,000,000
2 3,000,000 1,500,000
3 3,500,000 1,500,000
4 3,000,000 500,000

a) Calculate the payback period for each project.

b) Calculate the internal rate of return of each project. Which project should be accepted if they are independent? If they are mutually exclusive? (HINT - USE EXCELL)

c) Calculate the profitability index of each project. Which project should be accepted if they are independent? If they are mutually exclusive?

4) Why do many managers prefer to use the IRR rather than the NPV?

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