Question 1 (Capital Budgeting)

ABC Company is considering a new product line to supplement its range line. It is anticipated that the new product line will involve cash investment of $700,000 at time 0 and $1.0 million in year 1. After-tax cash inflows of $250,000 are expected in year 2, $300,000 in year 3, $350,000 in year 4, and $400,000 each year thereafter through year 10. Though the product line might be viable after year 10, the company prefers to be conservative and end all calculations at that time.

a) If the required rate of return is 15 percent, what is the net present value (NPV) of the project? Is it acceptable?

b) What is its profitability index (PI) of the project?

c) What would be the case if the required rate of return was 10 percent?

d) What is the projects payback period? Is it acceptable?

e) Briefly compare and contrast the NPV, PI, and IRR criteria. What are the advantages and disadvantages of using each of these methods?