Case Study Problem: ABC Corporation is considering investing in a new project that requires an initial investment of ₱500,000. The project is expected to generate cash flows of ₱150,000 per year for the next 6 years. The company’s cost of capital is 10%. The company uses the net present value (NPV) method to evaluate investment decisions. Should ABC Corporation invest in the new project? Questions: 1. What is the net present value of the new project? 2. Should ABC Corporation invest in the new project based on the net present value? 3. What is the internal rate of return (IRR) of the new project? 4. Should ABC Corporation invest in the new project based on the internal rate of return? 5. What is the payback period of the new project? 6. Should ABC Corporation invest in the new project based on the payback period?
ABC Corporation is facing a critical investment decision regarding a new project that requires an initial capital outlay of ₱500,000. This case study aims to assess the feasibility of the project by employing various financial metrics, including the Net Present Value (NPV), Internal Rate of Return (IRR), and Payback Period. These metrics will aid in determining whether ABC Corporation should proceed with the investment opportunity or not.
The Net Present Value is a widely used financial metric for evaluating investment decisions. It quantifies the potential profitability of a project by calculating the difference between the present value of cash inflows and the present value of cash outflows. In this case, the project is expected to generate ₱150,000 in cash flows annually for the next 6 years and has an initial investment of ₱500,000. The cost of capital for ABC Corporation is 10%.
NPV Calculation: NPV = ∑ [Cash Flow / (1 + r)^t] – Initial Investment NPV = ₱150,000 / (1 + 0.10)^1 + ₱150,000 / (1 + 0.10)^2 + ₱150,000 / (1 + 0.10)^3 + ₱150,000 / (1 + 0.10)^4 + ₱150,000 / (1 + 0.10)^5 + ₱150,000 / (1 + 0.10)^6 – ₱500,000 NPV ≈ ₱73,131.90
Should ABC Corporation Invest Based on NPV? The positive NPV of approximately ₱73,131.90 indicates that the project is expected to generate a return greater than the company’s cost of capital. Therefore, ABC Corporation should consider investing in the new project, as it is likely to create value for the company and enhance shareholder wealth.
Internal Rate of Return (IRR): The Internal Rate of Return is another crucial metric used in investment analysis. It represents the discount rate at which the Net Present Value of a project becomes zero. In simpler terms, it is the project’s expected annualized return rate.
IRR Calculation: IRR can be calculated using financial software or spreadsheet functions. For this project, the IRR is approximately 18.4%.
Should ABC Corporation Invest Based on IRR? An IRR of approximately 18.4% exceeds the company’s cost of capital (10%). Therefore, the project is expected to generate a return that surpasses the minimum required rate of return, making it an attractive investment opportunity for ABC Corporation.
Payback Period: The payback period indicates the time it takes for an investment to recoup its initial investment through generated cash flows. It’s a simple metric used to assess the project’s risk and liquidity.
Payback Period = Initial Investment / Annual Cash Flows Payback Period = ₱500,000 / ₱150,000 ≈ 3.33 years
Should ABC Corporation Invest Based on the Payback Period? The calculated payback period of approximately 3.33 years suggests that ABC Corporation will recover its initial investment within this timeframe. This relatively short payback period indicates lower risk associated with the investment.
In conclusion, the analysis of the new project using financial metrics reveals that ABC Corporation should invest in the project. Both the Net Present Value (NPV) and Internal Rate of Return (IRR) metrics indicate that the project is expected to generate positive returns and exceed the company’s cost of capital. Additionally, the relatively short payback period further supports the investment decision, as it ensures a relatively quick recovery of the initial investment. Therefore, ABC Corporation should proceed with the project, as it appears to be a financially sound and profitable opportunity.
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