Question

NPV Valuation. The Yurdone Corporation wants to set up a private cemetery business. According to the CFO, Barry M. Deep, business is "looking up." As a result, the cemetery project will provide a net cash inflow of S109,OOO for the firm during the first year, and the cash flows are projected to grow at a rate of 5.1% per year forever. The project requires an initial investment of $1,425,000. a. If Yurdone requires a return of 12 percent on such undertakings, should the cemetery business be started? b. The company is somewhat unsure about the assumption of a 5.1 percent growth rate in its cash flows. At what constant growth rate would the company just break even if it still required a return of 12 percent on its investment?

Answer 1

Answer:

a. The cemetery business be started

b. The company will just break even at a constant growth rate of 4.4%

Explanation:

A. To know whether to start the cemetery business or not, we need to subtract the present value of the initial outlay to generate the NPV and if the result is positive, it will be advisable to start the business and if otherwise, it won't be advisable to start the cemetery business.

This is a question on perpetuity growth. let us extract the information in the question

Initial investment                =   $1,425,000

Cash inflow in year 1 (C)     =   $109,000

Cost of capital (r)                 =   12%

Growth Rate (g)                    =   5.1%

Net Present Value (NPV)     =   PV of Growing Perpetuity - Initial

                                                   investment

                                      NPV =    {C/(r-g)} - Initial Investment

                                       NPV =   {109,000 /(12% - 5.1%)} - 1,425,000

                                       NPV =   {109,000 /(0.12 - 0.5.1)} - 1,425,000

                                        NPV =   {109,000 /(0.69)} - 1,425,000

                                        NPV =   1,579,710.15 - 1,425,000

                                        NPV =   $154,710.15

Since the net present value (NPV) of the project is positive, the cemetery business should be started.

b. At break even, PV of Growing Perpetuity = Initial investment

                                      C/(r-g)   =  Initial investment

                    Initial investment   =  1,425,000              

                                              C   =  $109,000

                                               r    =  12%

                                               g   =  Unknown

                    109,000 /(12% - g)  = 1,425,000          

                    109,000 /(0.12 - g)  = 1,425,000

                  1,425,000 (0.12 - g)  = 109,000

              171,000 -  1,425,000g  = 109,000

                             - 1,425,000g  = 109,000 -  171,000

                             - 1,425,000g  = -62,000

        - 1,425,000g/ - 1,425,000  = -62,000/- 1,425,000

                                                g   = 0.04351

Convert the answer to percentage 0.04351 * 100% = 4.4%

That is, the company will just break even at a constant growth rate of 4.4%