Projected Total Cash Flow and Value

Given the information we've accumulated, we can finish the preliminary cash flow analysis as illustrated in Table 10.5.

Now that we have cash flow projections, we are ready to apply the various criteria we discussed in the last chapter. First, the NPV at the 20 percent required return is:

NPV = -$110,000 + 51,780/1.2 + 51,780/1.22 + 71,780/1.23 = $10,648

So, based on these projections, the project creates over $10,000 in value and should be accepted. Also, the return on this investment obviously exceeds 20 percent (because the NPV is positive at 20 percent). After some trial and error, we find that the IRR works out to be about 25.8 percent.

In addition, if required, we could go ahead and calculate the payback and the average accounting return, or AAR. Inspection of the cash flows shows that the payback on this project is just a little over two years (verify that it's about 2.1 years).7

From the last chapter, we know that the AAR is average net income divided by average book value. The net income each year is $21,780. The average (in thousands) of the four book values (from Table 10.2) for total investment is ($110 + 80 + 50 + 20)/4 = $65. So the AAR is $21,780/65,000 = 33.51 percent.8 We've already seen that the return on this investment (the IRR) is about 26 percent. The fact that the AAR is larger illustrates again why the AAR cannot be meaningfully interpreted as the return on a project.

6In reality, the firm would probably recover something less than 100 percent of this amount because of bad debts, inventory loss, and so on. If we wanted to, we could just assume that, for example, only 90 percent was recovered and proceed from there.

7We're guilty of a minor inconsistency here. When we calculated the NPV and the IRR, we assumed that all the cash flows occurred at end of year. When we calculated the payback, we assumed that the cash flows occurred uniformly throughout the year.

8Notice that the average total book value is not the initial total of $110,000 divided by 2. The reason is that the $20,000 in working capital doesn't "depreciate."

Ross et al.: Fundamentals of Corporate Finance, Sixth Edition, Alternate Edition

IV. Capital Budgeting

10. Making Capital Investment Decisions

© The McGraw-Hill Companies, 2002

CHAPTER 10 Making Capital Investment Decisions

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