Question

(Ignore income taxes in this problem.) Laura Summers, the CFO of American Colonoscopy Center is considering opening a new center in New York. She would need to purchase a set of colonoscope, endoscopy snare, flexible sigmoidoscope and enteroscope costing $1,000,000 to equip the new center. The project would require additional working capital of $500,000 which would be released for use elsewhere at the end of the project. Laura 's marketing studies indicate that the annual cash inflow from the business will amount to $360,000. Laura wants to operate the colonoscopy center business for only six years. She estimates that the equipment could be sold at that time for about 10% of its original cost. Laura's required rate of return is 15%.

Required:

If asked, would you recommend this investment? Please explain and show your work.

Answer 1

Colonoscopy	0	1	2	3	4	5	6
Investment	-1,000,000
NWC	-500,000						500,000
Salvage							100,000
Cash Flows	-1,500,000	360,000	360,000	360,000	360,000	360,000	960,000
IRR	17.58%

Calculate the cash flows and IRR of the project.

The working capital will be recovered at the end of the six years and the equipment will be sold at 10% x 1m = 100,000 then.

Hence, last year cash flows = 360,000 + 100,000 + 500,000 = 960,000

IRR can be calculated using IRR function in excel or calculator

Insert CF0 = -1,500,000, CF1...CF5 = 360,000, CF6 = 960,000

=> Compute IRR = 17.58% > required return = 15%

Hence, Laura should invest in the project as she would earn more return than her required rate of return.