Question

Sorenson Motors (SM) is considering a project that has the following cash flows:

Year Cash Flow

0 Initial Outlay
1 $2,000
2 3,000
3 3,000
4 1,500

The project has a payback period of 2.5 years. The weighted average cost of capital is 12%. Which of the following statements is NOT correct?

	a. Acceptance of this project would increase SM’s value by $7,265.91.
	b. The project is expected to generate $1.12 for each $1.00 of investment.
	c. If SM were to accept this project, its shareholders wealth would increase by $765.91.
	d. The project is generating more cash than is needed to service its debt, and this excess cash accrues solely to SM’s stockholders

Answer 1

Since payback period is 2.5, it is recovery the initial cash flow in 2.5 years. Therefore, Initial cash flow will be full cash flow of year 1 plus full cash flow of yera 2 and 0.5 cash flow of year 3

Initial outlay = 2,000 + 3,000 + (0.5*3,000)

Initial outlay = $6,500

NPV = Present value of cash inflows - Present value of cash outflows

NPV = -6500 + 2000/(1 + 0.12)^1 + 3000/(1 + 0.12)^2 + 3000/(1 + 0.12)^3 + 1500/(1 + 0.12)^4

NPV = $765.91

The value will increase by $765.71

Therefore, below statment is incorrect

a. Acceptance of this project would increase SM’s value by $7,265.91.