In-Class Illustration #1

Norman, general manager of the XYZ subsidiary of Innovation Inc., is considering the purchase of new industrial equipment to improve efficiency at its Cordoba plant. The equipment has an estimated useful life of five years. The estimated cash flows for the equipment are shown in the table that follows, with no anticipated change in working capital. Innovation has a 12% required rate of return. Assume amortization is calculated on a straight line basis. Assume all cash flows occur at year-end except for initial investment amounts.

Initial investment $80,000

Annual cash flow from operations (excluding

the amortization effect) $31,250

Cash flow from terminal disposal of equipment $ 0

Required:

1. Calculate (a) net present value, (b) payback period and (c) internal rate of return.
2. The controller of Innovation Inc. received Normans estimates but adjusted them to capture the added risk of doing the project. Recalculate item 1 with a required rate of return of 20% and explain if the project will be approved by Innovation Inc. for its subsidiary.