Question

Walton Enterprises, Inc. is considering a proposal for a joint venture that will require an initial investment of $13,000,000. At the end of the fifth year, Walton’s joint venture partner will buy out Walton’s interest for $10,000,000. Walton expects the project to generate cash flows of $3,000,000 during the investment holding period. Walton’s CFO indicated that 12 per cent is the firm’s required rate of return. Required: Construct a discounted cash flow (DCF) model and calculate the proposal’s net present value (NPV) and internal rate of return. Based on your calculations above, make a summary recommendation (in one sentence) to the CFO concerning whether Walton should enter into this joint venture.

Answer 1

To assess the joint venture proposal for Walton Enterprises, Inc., compute the NPV and IRR by discounting the future cash flows and buyout value at the required rate of return of 12%. Summing the discounted cash flows and comparing them with the initial investment determines the NPV. A positive NPV would recommend proceeding with the investment, while a negative NPV would suggest otherwise.

Step-by-step explanation:

To calculate the net present value (NPV) for Walton Enterprises' potential joint venture, we must discount the future cash flows and the buyout amount back to present value, using the firm's required rate of return of 12%. The cash flows generated during the investment holding period are $3,000,000, and the buyout at the end of the fifth year is $10,000,000. We calculate the present value (PV) of each cash flow separately using the formula PV = FV / (1 + r)^n, where FV is the future value, r is the discount rate, and n is the number of periods.

Assuming cash flows occur at the end of each year, the calculation is as follows:

• Year 1-5: $3,000,000 / (1 + 0.12)^n for each year (n is the year number)
• Buyout in Year 5: $10,000,000 / (1 + 0.12)^5

After calculating the present values, we sum them up and subtract the initial investment to determine the NPV. If the NPV is positive, it means the investment would generate more than the required rate of return, and if negative, it would generate less.

To calculate the internal rate of return (IRR), we need to find the discount rate that makes the NPV of the cash flows equal to zero. This usually requires iterative calculation or the use of financial software, as there is no direct formula for IRR.

A summary recommendation can be made based on whether the NPV is positive or negative, which indicates if the joint venture meets the firm's required return expectations.