The Ambergast Corporation is considering a project with a 3-year lifespan and an initial cost of $1,200. The project is expected to generate annual savings of $360 for each of the three years.
Required:
Evaluate the feasibility of this project based on financial analysis methods such as Net Present Value (NPV), Internal Rate of Return (IRR), or Payback Period.
The Correct Answer and Explanation is:
To evaluate the feasibility of The Ambergast Corporation’s project, we will apply three key financial analysis methods: Net Present Value (NPV), Internal Rate of Return (IRR), and Payback Period.
Assumptions:
- Initial investment: $1,200
- Annual savings (cash inflow): $360 for 3 years
- Discount rate (assumed): 10%
1. Payback Period
The payback period is the time it takes to recover the initial investment. Payback Period=Initial InvestmentAnnual Cash Inflow=1,200360≈3.33 years\text{Payback Period} = \frac{\text{Initial Investment}}{\text{Annual Cash Inflow}} = \frac{1,200}{360} \approx 3.33 \text{ years}
Since the project only lasts 3 years, and the payback period is 3.33 years, the investment is not fully recovered within the project’s lifespan. This is a negative indicator.
2. Net Present Value (NPV)
NPV=∑t=13360(1+0.10)t−1,200NPV = \sum_{t=1}^{3} \frac{360}{(1+0.10)^t} – 1,200 NPV=3601.10+3601.21+3601.331−1,200NPV = \frac{360}{1.10} + \frac{360}{1.21} + \frac{360}{1.331} – 1,200 NPV≈327.27+297.52+270.50−1,200=895.29−1,200=−304.71NPV \approx 327.27 + 297.52 + 270.50 – 1,200 = 895.29 – 1,200 = -304.71
NPV = -$304.71, which means the project would decrease the firm’s value, hence it is not financially viable.
3. Internal Rate of Return (IRR)
We solve for IRR using the formula: 0=∑t=13360(1+IRR)t−1,2000 = \sum_{t=1}^{3} \frac{360}{(1+\text{IRR})^t} – 1,200
Using a financial calculator or Excel:
IRR ≈ 2.8%
This is far below the assumed discount rate of 10%, indicating the return on investment is not attractive.
Conclusion:
Based on the analysis:
- Payback Period exceeds the project life,
- NPV is negative, and
- IRR is below the cost of capital.
Therefore, The Ambergast Corporation should not proceed with the project as it is financially unfeasible.
