Question

The Bull Company, a lawn mower manufacturer, is considering the introduction of a new model. The initial investment required is $22 million. Net cash flows over the 4-year life cycle and the corresponding certainty-equivalents of the new model are as follows:

Year	Net Cash Flow	Certainty-equivalent
1	$15 million	0.90
2	13 million	0.75
3	11 million	0.55
4	9 million	0.30

  
The firm’s cost of capital is 12% and the risk-free rate is 8%. Bull uses the certainty-equivalent approach in evaluating above-average risk investments such as this one. What is the project’s certainty-equivalent NPV?

		$15,305,620
		$6,628,400
		$5,646,320
		$3,848,380

Answer 1

The NPV is computed as shown below:

= Initial investment + Present value of future cash flows

Present value is computed as follows:

= Future value / (1 + r)ⁿ

So, the NPV is computed as follows:

= - $ 22 million + ($ 15 million x 0.90) / 1.08 + ($ 13 million x 0.75) / 1.08² + ($ 11 million x 0.55) / 1.08³ + ($ 9 million x 0.30) / 1.08⁴

= - $ 22 million + $ 13.5 million / 1.08 + $ 9.75 million / 1.08² + $ 6.05 million / 1.08³ + $ 2.7 million / 1.08⁴

= $ 5.646319159 million or $ 5,646,320 Approximately

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