Question

Question 3. The Yurdone Corporation wants to set up a private cemetery business. According tothe CFO, Barry M. Deep, business is “looking up.” As a result, the cemetery project will providea net cash inflow of $135,000 for the firm during the first year, and the cash flows are projected to grow at a rate of 4.7 percent per year forever. The project requires an initial investment of $1,575,000.

1. If Yurdone requires a return of 12 percent on such undertakings, should the cemetery business be started?

2. The company is somewhat unsure about the assumption of a 4.7 percent growth rate in its cash flows. At what constant growth rate would the company just break even if it still required a return of 12 percent on its investment?

Please provide a timeline and show all forumlas used.

Answer 1

1]

NPV of business = present value of cash inflows - initial investment

present value of growing perpetuity = first payment / (required return - growth rate)

present value of cash inflows = $135,000 / (12% - 4.7%)

present value of cash inflows = $1,849,315.07

NPV of business = $1,849,315.07 - $1,575,000

NPV of business = $274,315.07

Yes, the business should be started as the NPV is positive

2]

To break even, the NPV should be zero

NPV of business = present value of cash inflows - initial investment

Let us say the growth rate is G. Then :

$0 = ($135,000 / (12% - G)) - $1,575,000

G = 12% - ($135,000 / $1,575,000)

G = 3.43%

The company would break even at 3.43% growth rate