Final answer:
Plano Company should accept the project if the Net Present Value (NPV) is positive. The NPV is positive when the present value of future cash flows generated by the project is greater than the initial investment. A positive NPV of $0.89 million means the project will add value to the firm.
"The correct option is approximately option E"
Step-by-step explanation:
The question at hand is whether Plano Company should accept the project of purchasing a production facility at a cost of $22.78 million, expecting to generate annual cash flows of $7 million over the next five years, with a cost of capital of 18 percent. To assess the viability of this investment, the Net Present Value (NPV) must be calculated by discounting the future cash flows at the cost of capital and subtracting the initial investment. If NPV is positive, it implies the project will add value to the firm.
To calculate NPV, we would discount each of the $7 million cash flows back to their present values using the formula:
Present Value = Future Cash Flow / (1 + Discount Rate)Number of Years
Adding up all the present values of the cash flows over the five years and subtracting the initial investment will give us the NPV. We do not have the exact figures for the NPV from the question, however, if the firm has an NPV of $0.89 million, it means the project should be accepted because it has a positive NPV, which adds value to the company.
If the firm's discounted payback period is 3 years, it means it recovers the initial investment in less than the project's lifespan, which could be a good indicator as well, but a full NPV analysis is more conclusive. The correct course of action is usually to accept projects with a positive NPV, which in this case, based on the provided options, confirms the project is financially worth pursuing.