Question: At the end of 2015, Uma Corporation is considering undertaking a major long-term project in an effort to remain competitive in its industry. The production and sales departments have determined the potential annual cash flow savings that could accrue to the firm if it acts soon. Specifically, they estimate that a mixed stream of future cash flow savings will occur at the end of the years 2016 through 2021. The years 2022 through 2026 will see consecutive and equal cash flow savings at the end of each year. The firm estimates that its discount rate over the first 6 years will be 7%. The expected discount rate over the years 2022 through 2026 will be 11%. The project managers will find the project acceptable if it results in present cash flow savings of at least $860,000. The following cash flow savings data are supplied
|
End of year
|
Cash flow savings
|
|
2016
|
$110,000
|
|
2017
|
120,000
|
|
2018
|
130,000
|
|
2019
|
150,000
|
|
2020
|
160,000
|
|
2021
|
150,000
|
|
2022
|
90,000
|
|
2023
|
90,000
|
|
2024
|
90,000
|
|
2025
|
90,000
|
|
2026
|
90,000
|
TO DO: Create spreadsheets similar to Table 5.2, and then answer the following questions.
a. Determine the value (at the beginning of 2016) of the future cash flow savings expected to be generated by this project.
b. Based solely on the one criterion set by management, should the firm undertake this specific project? Explain.
c. What is the "interest rate risk," and how might it influence the recommendation made in part b? Explain.
Gitman, Lawrence J.; Zutter, Chad J.. Principles of Managerial Finance, Brief (Pearson Series in Finance) (Page 209). Pearson Education. Kindle Edition.