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China Importers would like to spend $215,000 to expand its warehouse. However, the company has a loan outstanding that must be repaid in 2.5 years and thus will need the $215,000 at that time. The warehouse expansion project is expected to increase the cash inflows by $60,000 in the first year, $140,000 in the second year, and $150,000 a year for the following 2 years. Should the firm expand at this time?

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jepessoa

Answer:

China Importers should expand their warehouse since the payback period for the investment is less than 2.5 years. By the time the company needs to pay its debt it will have more than recovered the money they invested in the warehouse expansion.

Explanation:

China Importers' cash flow:

Year 1:                                                                 Accumulated cash flow:

-$215,000 (warehouse expansion)                    -$215,000

+$60,000 (increased cash flows)                      -$155,000

Year 2:

+$140,000 (increased cash flow)                       -$15,000

Year 3:

first half of year 3.-

+$75,000 (increased cash flow)                         $60,000

second half of year 3.-

+$75,000 (increased cash flow)                         $125,000

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