Question

The Argyll Corporation wants to set up a private cemetery business. According to the CFO, Kepler Wessels, business is “looking up.” As a result, the cemetery project will provide a net cash inflow of $97,000 for the firm during the first year, and the cash flows are projected to grow at a rate of 6 percent per year, forever. The project requires an initial investment of $1,500,000. a. If Argyll requires an 11 percent return on such undertakings, should the cemetery business be started? b. The company is somewhat unsure about the assumption of a 6 percent growth rate in its cash flows. At what constant growth rate would the company just break even if it still required an 11 percent return on investment?

Answer 1

a). PV of cash inflows = C1 / (R - g)

= $97,000 / (0.11 - 0.06)

= $1,940,000

NPV = PV of Cash Inflows - PV of Cash Outflows = $1,940,000 - $1,500,000 = $440,000

The NPV is positive, so we would accept the project.

b). We wan to know the minimum growth rate in CFs necessary to accept the project. The minimum growth rate is the growth rate at which we would have a zero NPV.

NPV = [$97,000 / (0.11 - g)] - $1,500,000 = 0

$97,000 / (0.11 - g) = $1,500,000

0.11 - g = $97,000 / $1,500,000

g = 0.11 - 0.0647 = 0.453, or 4.53%