PROBLEM #1: CAPITAL INVESTMENT ANALYSIS Arroyo Company is considering inves

PROBLEM #1: CAPITAL INVESTMENT ANALYSIS

Arroyo Company is considering investing in a second manufacturing plant due its recent growth in sales.

The proposed plant would require an initial cash investment of $600000.

The plant would have a two-year life. Forecasted cash revenues and cash costs are:

Cash revenues

Year 1: 235000 units to be sold at $2.10 each

Year 2: 250000 units to be sold at $2.25 each

Cash costs

Fixed costs: $120000 in year #1 and $125000 in year #2

Variable costs: $.25 per unit in year #1 and $.30 per unit in year #2

Additionally the project will provide salvage value of $25000 at the end of year #2. Arroyo Company requires a 10% return on
investment.

Required:

1. Calculate the net cash flows for year #1 and year #2. Include the salvage value as a cash
receipt at the end of year #2.

2. Compute the present value of net cash flows. Should Arroyo invest in the project?

3. Now suppose interest rates rise as the Federal Reserve Board raises interest rates to
combat inflation. The company now requires a 12% return. Using net present value techniques recalculate the net present value of the project using a discount
rate of 12%. Should Arroyo invest in the project?

4. What do the results of this problem tell you about the effects of rising interest rates on
capital investments?