Question

Read the scenario.

You are the financial manager of a firm that is contemplating investing $25,000 in a new project that you expect will generate cash flows of $10,000 per year for five years and then $15,000 per year for another two years. At the end of seven years you expect to sell the project's assets for $50,000. You believe that you should earn at least 14% to compensate the shareholders for the project's risk.

Step 2

Answer the questions.

Answer the following questions:

• Explain the process for evaluating this project.
• What is the present value of the project's terminal value?
• What is the most that you should pay for this project?
• What is the Profitability Index?
• What is the Pay Back Period?
• Is this project consistent with the firm's goal assuming you can invest $25,000 in this project?
• What is the primary goal of the firm?

Answer 1

Explain the process for evaluating this project.
Discount the cash outflows and inflows

What is the present value of the project's terminal value?
=50000/1.14^7=19981.86613

What is the most that you should pay for this project?
=50000/1.14^7+10000/14%*(1-1/1.14^7)+15000/1.14^6+15000/1.14^7=75693.27257

What is the Profitability Index?
=1+(50000/1.14^7+10000/14%*(1-1/1.14^7)+15000/1.14^6+15000/1.14^7)/25000=4.027730903

What is the Pay Back Period?
=2.5 years

Is this project consistent with the firm's goal assuming you can invest $25,000 in this project?
Yes

What is the primary goal of the firm?
Maximize shareholders value