Question

The Bull Company, a lawn mower manufacturer, is considering the introduction of a new model. The...

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

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

Feel free to ask in case of any query relating to this question