Self-Correction Problems 1.

Briarcliff Stove Company is considering a new product line to supplement

its range line. It is is anticipated that new product line will involve cash investment
of $700,000.00 at time 0 and $1,000,000.00 in year 1. After tax cash flows of $250,000
are expected in year 2, $300,000 in year 3, $350,000 in year 4, and $400,000 year
thereafter through year 10. Although the product line might be viable after 10 years,
the company prefers to be conservative and end all calculations at that time.

a- If the required rate of return is 15 percent, what is the net present value of the project?
is it acceptable?
b- What is the internal rate of return?
c- What would be the case if the required rate of return were 10 percent? This Model is prepared by Rajib Dahal. If you need
d- What is the project's payback period? excelsheet calculation, please contact me at my email at
rajib.dahal@nu.edu.kz/rajib.dahal@gmail.com
Discount rate: 15% 13 Capital Budgeting Techniques, Part V: Investment in Capital Assets, Self-Correction Problems at Page No. 346
Discounted Cash Flow Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10
Years 0 1 2 3 4 5 6 7 8 9 10
Cash Investment (700,000) (1,000,000)
Cash inflows 250,000 300,000 350,000 400,000 400,000 400,000 400,000 400,000 400,000
Discount factor 1.00 0.87 0.76 0.66 0.57 0.50 0.43 0.38 0.33 0.28 0.25
Discounted Cash flow (700,000) (869,565) 189,036 197,255 200,114 198,871 172,931 150,375 130,761 113,705 98,874
NPV (117,645)

a. When the required rate of return is 15%, the NPV is negative. So, the project will not be acceptable.
b.IRR The cash flows relevant for computing IRR are: (700,000) (1,000,000) 250,000 300,000 350,000 400,000 400,000 400,000 400,000 400,000 400,000
So, IRR 13.20%
c. When the discount rate is 10%, the NPV is positive and the project is acceptable. See the computation below.
IRR when discount rate is 10%: IRR is independant of discount rate. It depends on cashflows and will not change from 13.20% as computed in b.
Discounted Cash Flow Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10
Years 0 1 2 3 4 5 6 7 8 9 10
Cash Investment (700,000) (1,000,000)
Cash inflows 250,000 300,000 350,000 400,000 400,000 400,000 400,000 400,000 400,000
Discount factor 1.00 0.91 0.83 0.75 0.68 0.62 0.56 0.51 0.47 0.42 0.39
Discounted Cash flow (700,000) (909,091) 206,612 225,394 239,055 248,369 225,790 205,263 186,603 169,639 154,217
NPV 251,850

d. Project payback Period (PBP) 6 years as by that time, the project recovers 1.7 mn US$ which it has invested in year 0 and 1.

Computation of PBP: Total Cash outflows (1,700,000)

Year of Cash inflows Amount Cumulative amount

2 250,000.00 250,000.00
3 300,000.00 550,000.00
4 350,000.00 900,000.00
5 400,000.00 1,300,000.00
6 400,000.00 1,700,000.00 As can be seen from the computation, the cashinflows at the end of 6 years match the cash outflows of years 0 and 1 and therefore, PBP is 6 years.