Question

# 1. Net present value (NPV) Evaluating cash flows with the NPV method The net present value...

1. Net present value (NPV)

Evaluating cash flows with the NPV method

The net present value (NPV) rule is considered one of the most common and preferred criteria that generally lead to good investment decisions.

Consider this case:

Suppose Happy Dog Soap Company is evaluating a proposed capital budgeting project (project Alpha) that will require an initial investment of \$400,000. The project is expected to generate the following net cash flows:

Year

Cash Flow

Year 1 \$375,000
Year 2 \$400,000
Year 3 \$425,000
Year 4 \$450,000

Happy Dog Soap Company’s weighted average cost of capital is 7%, 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)?

A\$1,188,086

B\$1,415,072

C\$990,072

D\$1,365,072

Making the accept or reject decision

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 (Accept or Reject) project Alpha.

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 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.

B-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.

C-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.

 Calculation of NPV Year Cashflow (\$) Discounting factor @ 7% PV of cashflows (\$) 0 -400000 1 -400000 1 375000 0.934579439 350467 2 400000 0.873438728 349375 3 425000 0.816297877 346927 4 450000 0.762895212 343303 NPV 990072 We know, NPV= Present value of future cashflows discounted at the required rate of return NPV= \$990072 As the NPV is positive, company should accept the project. Answer: Option C If the project has a NPV of \$0, the project is earning a rate of return equal to the project's weighted average cost of capital. Its ok to accept a project with an NPV of \$0, because the project is earning the required minimum rate of return. Answer: Option B

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