Final answer:
AdventureParks Ltd is evaluating the construction of a new theme park. This can be assessed by calculating the NPV profile, identifying the IRR, and comparing the NPV of the project to zero. The cost of capital estimate can also be tested by calculating the NPV at different discount rates.
Step-by-step explanation:
AdventureParks Ltd is evaluating the construction of a new theme park. The theme park would cost $495 million and would operate for 20 years. AdventureParks expects annual cash flows from operating the theme park to be $70.6 million and its cost of capital is 12.0%.
a. To prepare an NPV profile of the purchase, calculate the net present value (NPV) of the cash flows for different discount rates. Discount rates typically range from 0% to the cost of capital (12% in this case), and the NPV is calculated by discounting the cash flows at each rate. Plotting these NPV values against the discount rate will give the NPV profile.
b. The internal rate of return (IRR) can be identified on the graph by finding the discount rate at which the NPV becomes zero. This is the level at which the project's cash inflows equal its cash outflows.
c. To determine whether AdventureParks should go ahead with the purchase, compare the NPV of the project to zero. If the NPV is positive, it indicates that the project will generate more cash inflows than it costs, and the purchase should be considered. If the NPV is negative, it implies that the project will not generate enough cash inflows to cover the costs and may not be a wise investment.
d. The cost of capital estimate for AdventureParks could be off by a certain percentage before the purchase decision would change. To determine the threshold, calculate the NPV with different discount rates within a reasonable range. If the NPV changes from positive to negative or vice versa, it indicates that the discount rate is at the threshold where the decision would change.