Case Analysis 1: You work for a small, local telecommunications company. In five
ID: 2614572 • Letter: C
Question
Case Analysis 1: You work for a small, local telecommunications company. In five years, the company plans to undertake a major upgrade to its servers and other IT infrastructure. Management estimates that it will need up to $450,000 to cover all related costs; however, as a fairly young company, the goal is to pay for the upgrade with cash and not to take out loans. Right now, you have $300,000 in a bank account established for Capital Investments. This account pays 4% interest, compounded annually. A member of the finance department has approached you with an investment opportunity for the $300,000 that covers a five-year period and has the following projected after-tax cash flows:
Year Projected Cash Flow
1 $90,000
2 $115,000
3 $135,000
4 $110,000
5 $90,000
Based on this information, in an MS Word document, answer the following questions:
1) How much money will be in the bank account if you leave the $300,000 alone (earning 4% compounded interest) until you need it in five years?
2) If you undertake the investment opportunity, what is the Nominal Payback Period?
3) Using the Present Value factors for 7% (which can be found on any PV Factor table), what is the discounted Payback Period of the investment opportunity?
4) What is the Net Present Value at 7% of the investment opportunity?
5) Which option (make the investment or leave the money in a savings account) would you recommend to your CEO? Why? What additional factors/information might make you change your point of view?
Explanation / Answer
1.Principal = 300,000
Interest = 4% compound interest
Value after 5 years = 300,000(1+0.04)5
=$364,995.87
2. Nominal Payback period is the time period in which the initial investment is recovered
Outflow = 300,000
Year
Cash Flow
Cumulative Cash Flows
1
90,000
90,000
2
115,000
205,000
3
135,000
340,000
4
110,000
450,000
5
90,000
540,000
Payback period will lie between 2 and 3 years
Payback Period = 2 + 95,000/(340,000-205,000)
=2.70 years
Discounted Payback Period: Discounted Cash Flows are taken in place of nominal cash flows.
Year
Cash Flows
PVF@7%
PV of Cash Flows
Cum. Cash Flows
1
90,000
0.935
84,150
84,150
2
115,000
0.873
100,395
184,545
3
135000
0.816
110,160
294,705
4
110,000
0.763
83,930
378,635
5
90,000
0.713
64,170
442,805
Discounted payback Period = 3 + (300,000-294705)/(378635-294705)
=3.06 years
4. Net Present Value = Present Value of Cash Inflow – Present Value of Cash Outflows
=422,805-300,000 = $142,805
5. Investment in the project is recommended, since Profit is more than what we will get in the savings account. Risk Associated with the project might change my view. If the Cash Flows are risky and uncertain in the project, I might want to go with the safe 4% interest in the savings Account
Year
Cash Flow
Cumulative Cash Flows
1
90,000
90,000
2
115,000
205,000
3
135,000
340,000
4
110,000
450,000
5
90,000
540,000
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