At the end of 2012 Omega Corporation was considering undertaking a major long-term project in an effort to remain competitive in its industry. The production and sales departments determined the potential annual cash flows savings that could accrue to the firm if it acts soon. Specifically, they estimate that a mixed stream of future cash flow saving will occur at the end of the years 2013 to 2018. The years 2019 to 2023 will see consecutive and equal cash flow savings at the end of each year. The firm estimates that its discount rate over the first six years will be 7%. The expected discount rate over the years 2019 to 2023 will be 11%. The project manager will find the project acceptable if it results in present cash flow saving of at least $860000. The following cash flow savings data are supplied to the finance department for analysis
End of year Cash flow savings ($)
1. Determine the value (at the beginning of 2013) of the cash flow savings expected to be generated by this project.
2. Based solely on one criterion set by the management, should the firm undertake the specific project? Explain.
3. What is the ‘interest rate risk’ and how might it influence the recommendation made in question 2?