Question

Suppose Happy Dog Soap Company is evaluating a proposed capital budgeting project (project Alpha) that will require an initial investment of $600,000. The project is expected to generate the following net cash flows:

Year Cash Flow

Year 1 $275,000

Year 2 $450,000

Year 3 $450,000

Year 4 $475,000

1. Happy Dog Soap Company’s weighted average cost of capital is 8%, and project Alpha has the same risk as the firm’s average project. Based on the cash flows, what is project Alpha’s net present value (NPV)?

2. Happy Dog Soap Company’s decision to accept or reject project Alpha is independent of its decisions on other projects. If the firm follows the NPV method, it should (reject or accept?) project Alpha.

3. Which of the following statements best explains what it means when a project has an NPV of $0?

A. When a project has an NPV of $0, the project is earning a rate of return equal to the project’s weighted average cost of capital. It’s OK to accept a project with an NPV of $0, because the project is earning the required minimum rate of return.

B. When a project has an NPV of $0, the project is earning a profit of $0. A firm should reject any project with an NPV of $0, because the project is not profitable.

C. When a project has an NPV of $0, the project is earning a rate of return less than the project’s weighted average cost of capital. It’s OK to accept the project, as long as the project’s profit is positive.

Answer 1

Net present value = Present value of cash inflows – Present value of cash outflows

= 275000/(1.08)^1 + 450,000/(1.08)^2 + 450,000/(1.08)^3 + 475000/(1.08)^4 – 600,000

= $746,795.79

2.Accept since NPV is positive

3. A. When a project has an NPV of $0, the project is earning a rate of return equal to the project’s weighted average cost of capital. It’s OK to accept a project with an NPV of $0, because the project is earning the required minimum rate of return.