Question

Suppose Celestial Crane Cosmetics is evaluating a

Suppose Celestial Crane Cosmetics is evaluating a proposed capital budgeting project (project Alpha) that will require an initial investment of $500,000. The project is expected to generate the following net cash flows:

Year	Cash Flow
Year 1	$350,000
Year 2	$450,000
Year 3	$450,000
Year 4	$450,000

Celestial Crane Cosmetics’s weighted average cost of capital is 10%, 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)?

$1,335,530

$1,185,530

$835,530

$335,530

Making the accept or reject decision

Celestial Crane Cosmetics’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. (accept/ reject)

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.

Answer 1

Answer a.

WACC = 10%

Net Present Value = -$500,000 + $350,000/1.10 + $450,000/1.10^2 + $450,000/1.10^3 + $450,000/1.10^4
Net Present Value = $835,530

Net Present Value of Project Alpha is $835,530

Answer b.

Celestial Crane Cosmetics’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 project Alpha.

Answer c.

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.