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 $450,000. The project is expected to generate the following net cash flows:
Year |
Cash Flow |
---|---|
Year 1 | $300,000 |
Year 2 | $475,000 |
Year 3 | $475,000 |
Year 4 | $425,000 |
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)?
$1,349,472
$1,224,472
$924,472
$1,399,472
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 ___ 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 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.
NPV = PV of future cash inflows – Initial investment
Year |
Cash Flow (C) |
Computation of PV Factor |
PV Factor @ 8 % (F) |
PV (C x F) |
0 |
- $ 450,000 |
1/ (1+0.08)0 |
1 |
-$450,000.00 |
1 |
$ 300,000 |
1/ (1+0.08)1 |
0.925925925925926 |
$277,777.78 |
2 |
$ 475,000 |
1/ (1+0.08)2 |
0.857338820301783 |
$ 407,235.94 |
3 |
$ 475,000 |
1/ (1+0.08)3 |
0.793832241020169 |
$ 377,070.31 |
4 |
$ 425,000 |
1/ (1+0.08)4 |
0.735029852796453 |
$ 312,387.69 |
NPV |
$ 924,471.72 |
NPV of Project Alpha is $ 924,472
If the firm follows the NPV method, it should accept the project.
Statement a explains best for a project with 0 NPV.
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.
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