Question

Garmen Technologies Inc. operates a small chain of specialty retail stores throughout the U.S. Southwest. The company markets technology-based consumer products both in its stores and over the Internet, with sales split roughly equally between the two channels of distribution. The company’s products range from radar detection devices and GPS mapping systems used in automobiles to home-based weather monitoring stations. The company recently began investigating the possible acquisition of a regional warehousing facility that could be used both to stock its retail shops and to make direct shipments to the firm’s online customers. The warehouse facility would require an expenditure of $250,000 for a rented space in Oklahoma City, Oklahoma, and would provide a source of cash flow spanning the next 10 years. The estimated cash flows are as follows:


The negative cash flow in Year 5 reflects the cost of a planned renovation and expansion of the facility. Finally, in Year 10 Garmen estimates some recovery of its investment at the close of the lease, and consequently a higher-than-usual cash flow. Garmen uses a 12 percent discount rate in evaluating its investments.
a. As a preliminary step in analyzing the new investment, Garmen’s management has decided to evaluate the project’s anticipated payback period. What is the project’s expected payback period? Jim Garmen, CEO, questioned the analyst performing the analysis about the meaning of the payback period because it seems to ignore the fact that the project will provide cash flows over many years beyond the end of the payback period. Specifically, he wanted to know what useful information the payback provides. If you were the analyst, how would you respond to Mr. Garmen?
b. In the past, Garmen’s management has relied almost exclusively on the IRR to make its investment choices. However, in this instance the lead financial analyst on the project suggested that there may be a problem with the IRR because the sign on the cash flows changes three times over its life. Calculate the IRR for the project. Evaluate the NPV profile of the project for discount rates of 0 percent, 20 percent, 50 percent, and 100 percent. Does there appear to be a problem of multiple IRRs in this range of discount rates?
c. Calculate the project’s NPV. What does the NPV indicate about the potential value created by the project? Describe to Mr. Garmen what NPV means, recognizing that he was trained as an engineer and has no formal businesseducation.


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  • CreatedOctober 31, 2014
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