PROBLEM #1: CAPITAL INVESTMENT ANALYSIS

Arroyo Company is considering investing in a second manufacturing plant, due its recent growth in sales.

The proposed plant would require an initial cash investment of $600,000.

The plant would have a two-year life. Forecasted cash revenues and cash costs are:

Cash revenues

Year 1: 235,000 units to be sold at $2.10 each

Year 2: 250,000 units to be sold at $2.25 each

Cash costs

Fixed costs: $120,000 in year #1 and $125,000 in year #2

Variable costs: $.25 per unit in year #1 and $.30 per unit in year #2

Additionally, the project will provide salvage value of $25,000 at the end of year #2. Arroyo Company requires a 10% return on investment.

Required:

1. Calculate the net cash flows for year #1 and year #2. Include the salvage value as a cash receipt at the end of year #2.

2. Compute the present value of net cash flows. Should Arroyo invest in the project?

3. Now, suppose interest rates rise as the Federal Reserve Board raises interest rates to combat inflation. The company now requires a 12% return. Using net present value techniques recalculate the net present value of the project, using a discount rate of 12%. Should Arroyo invest in the project?

4. What do the results of this problem tell you about the effects of rising interest rates on capital investments?