Final answer:
To determine if James's project is financially viable, we must calculate the net present value (NPV) of its future cash flows, adjusted for inflation and running costs, discounted at the company's required rate of return of 16%. A positive NPV would indicate that the project meets the desired return threshold.
Step-by-step explanation:
To assess whether James's project is worthwhile, we need to calculate its net present value (NPV) using the provided financial figures and growth rates, and compare it to the company's required rate of return. This involves detailing each year's net cash flows by considering the anticipated benefits, savings with inflation adjustments, and rising running costs due to inflation. Then, we discount these cash flows back to their present value using the company's required rate of return of 16%. The NPV, if positive, would suggest the project is financially viable.
To calculate this, we need to follow these steps:
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- Determine the fixed annual income of $3,500.
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- Calculate the increasing annual savings starting at $500, with a 5% inflation adjustment each year.
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- Estimate the escalating annual running costs starting at $1,300, with a 10% inflation adjustment each year.
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- Compute the discounted cash flow for each year over the 4-year period using the formula for the present value of an annuity.
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- Add up the discounted cash flows and subtract the initial investment of $10,000 to find the NPV.
If the NPV is greater than zero, the project surpasses the 16% required return and is considered worthwhile.