Garmen Technologies Ltd operates a small chain of speciality retail shops throughout Victoria

and Tasmania. The company markets technology-based consumer products both in its stores

and over the Internet, with sales split roughly equally between the two channels of

distribution. The companys products range from radar-detection devices and GPS mapping

systems used in cars to home-based weather monitoring stations. The company recently began

investigating the possible acquisition of a regional warehousing facility that could be used

both to stock its retail shops and to make direct shipments to the firms online customers. The

warehouse facility would require an expenditure of $250,000 for a rented space in Port

Melbourne, and would provide a source of cash flow spanning the next 10 years. The

estimated cash flows are as follows:

Year Cash Flow Year Cash Flow

0 $(250,000) 6 $65,000

1 60,000 7 65,000

2 60,000 8 65,000

3 60,000 9 65,000

4 60,000 10 90,000

5 (45,000)

Then negative cash flow in year 5 reflects the cost of a planned renovation and expansion of

the facility. Finally, in year 10, Garmen estimates some recovery of its investment at the close

of the lease, and consequently a higher-than-usual cash flow. Garmen uses a 12% discount

rate in evaluating its investments.

(a) As a preliminary step in analysing the new investment, Garmens management has

decided to evaluate the projects anticipated payback period. What is the projects

expected payback period? Jim Garmen, CEO, questioned the analyst performing the

analysis about the meaning of the payback period because it seems to ignore the fact that

the project will provide cash flows over many years beyond the end of the payback

period. Specifically, he wanted to know what useful information the payback provides. If

you were the analyst, how would you respond to Mr Garmen? (5 marks)

(b) In the past, Garmens management has relied almost exclusively on the IRR to make its

investment choices. However in this instance, the lead financial analyst on the project

suggested there may be a problem with the IRR because the sign on the cash flows

changes three times over its life. Calculate the IRR for the project. Evaluate the NPV

profile of the project for discount rates of 0%, 20%, 50% and 100%. Does there appear to

be a problem of multiple IRRs in this range of discount rates? To demonstrate your

explanation, draw a graph of the discount rate versus the NPV using the 4 given discount

rates.

(c) Calculate the projects NPV. What does the NPV indicate about the potential value

created by the project? Describe to Mr Garmen what NPV means, recognising that he

was trained as an engineer and has no formal business education.