Question

company that makes new furniture that has a worn look to it, has been struggling to keep up with its competitors. But the intern Igor has an idea: make some up-front investments in order to get customers' attention and then reap the rewards of a better product with a higher selling price. Since he's been studying capital budgeting at school, he's confident that he can present his idea and impress his boss with his insight and technical expertise. Here's the plan: - Invest $150,000 in updated equipment and inventory management technology to support the production of zero-defect products, where custom features can be reasonably added to any order on demand. - The new equipment and technology will have a useful life of 8 years, after which the assets will have no market value. - The assets will generate additional net cash inflows due to higher gross margins of $60,000 per year for the life of the assets, less additional operating cash outflows of $30,000 per year for persistent marketing efforts. Before pulling his proposal together, Igor finds out that the company is typically subject to a 24% tax rate. Further, the company has alternative uses for its cash that would easily earn a 6% rate of return. Required a. Is Igor's plan financially viable? Determine the NPV of this proposal and explain what it means if your answer is either a negative or a positive amount. b. Determine the exact IRR for this investment. Would Igor's proposal be acceptable to his boss based on this metric? c. What would the IRR of this investment be if the company actually generated $85,000 in additional net cash inflows for the last 4 years of its life (instead of the $60,000 noted above)? Does this scenario seem reasonable? Explain

Answer 1

NPV and IRR are used to assess the financial viability of Igor's plan, with positive NPV indicating value addition to the company and IRR comparing the return to the company's required rate. A recalculated IRR would reflect greater inflows in the last four years, but its feasibility depends on market conditions.

Step-by-step explanation:

To determine if Igor's plan is financially viable, we need to calculate the Net Present Value (NPV) and the Internal Rate of Return (IRR). NPV assesses the profitability of a project by discounting future cash flows to their present value and then comparing this with the initial investment. It helps determine if profits exceed costs.

To calculate NPV, we must consider:

• The initial investment ($150,000).
• The annual additional net cash flows ($60,000 - $30,000 = $30,000).
• The tax rate (24%).
• The discount rate (the alternative rate of return the company could earn, 6%).
• The useful life of the assets (8 years).

After tax, the annual net cash inflow is $30,000 * (1 - 0.24) = $22,800.

The NPV formula is:
NPV = ∑ (Cash inflow / (1 + r)^t) - Initial Investment, where r is the discount rate and t is the year.

We subtract the initial investment at the end to obtain the NPV. If the NPV is positive, it means the investment would add value to the company.

To calculate the exact IRR, we must find the discount rate that would set the NPV to zero, which can be found using financial calculators or software.

If the IRR exceeds the company's required rate of return (6%), Igor's proposal would be acceptable, as it indicates the investment promises a higher return than what could be earned elsewhere at the required rate.

Under the modified scenario with an increased inflow of $85,000 for the last 4 years, the IRR would be recalculated. Given the substantial increase, the IRR would likely rise, potentially making the investment even more attractive.

However, the reasonableness of this scenario depends on market conditions and the company's ability to meet the higher demand projections.