Question

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 Blue Hamster Manufacturing Inc. is evaluating a proposed capital budgeting project (project Beta) that will require an initial investment of $2,750,000. The project is expected to generate the following net cash flows:

Year	Cash Flow
Year 1	$325,000
Year 2	$475,000
Year 3	$500,000
Year 4	$400,000

Blue Hamster Manufacturing Inc.’s weighted average cost of capital is 7%, and project Beta has the same risk as the firm’s average project. Based on the cash flows, what is project Beta’s NPV?

a. -$1,318,071

b. -$1,515,782

c. -$918,071

d. -$4,068,071

Making the accept or reject decision

Blue Hamster Manufacturing Inc.’s decision to accept or reject project Beta is independent of its decisions on other projects. If the firm follows the NPV method, it should (accept/reject) project Beta?

Suppose your boss has asked you to analyze two mutually exclusive projects—project A and project B. Both projects require the same investment amount, and the sum of cash inflows of Project A is larger than the sum of cash inflows of project B. A coworker told you that you don’t need to do an NPV analysis of the projects because you already know that project A will have a larger NPV than project B. Do you agree with your coworker’s statement?

a. No, the NPV calculation is based on percentage returns, so the size of a project’s cash flows does not affect a project’s NPV.

b. Yes, project A will always have the largest NPV, because its cash inflows are greater than project B’s cash inflows.

c. No, the NPV calculation will take into account not only the projects’ cash inflows but also the timing of cash inflows and outflows. Consequently, project B could have a larger NPV than project A, even though project A has larger cash inflows.

Answer 1

1) Statement showing NPV

Year	Cash flow	PVIF @ 7%	PV
	A	B	C = A x B
1	325000	0.9346	303738
2	475000	0.8734	414883
3	500000	0.8163	408149
4	400000	0.7629	305158
Sum of PV of cash inflow	1431929
Less: Initial Investment	2750000
NPV	-1318071

Thus NPV = -$1318071

Ans) a. -$1,318,071

2) ans )

c. No, the NPV calculation will take into account not only the projects’ cash inflows but also the timing of cash inflows and outflows. Consequently, project B could have a larger NPV than project A, even though project A has larger cash inflows.

Though sum of cash inflow of project A is more than that of project B , it may be possible that larger amount of cash inflow occurs in early stage of B and latter stage of A and vice versa , hence it is necessary to calculate NPV to make better decision as it also takes into account timing of cash inflow