Question

Look back to the cash flows for projects F and G in Section 5-3.

FLOWS $ C4 Project C1 C5 IRR% NPV AT 10% CASH C2 C3 +5000 | +4000 +1800 +1800 0 0 ... 33 3592 -9000 -9000 +6000 +1800 +1800 +1800 20 9000

The cost of capital was assumed to be 10%. Assume that the forecasted cash flows for projects of this type are over- stated by 8% on average. That is, the forecast for each cash flow from each project should be reduced by 8%. But a lazy financial manager, unwilling to take the time to argue with the projects’ sponsors, instructs them to use a discount rate of 18%.
a. What are the projects’ true NPVs?
b. What are the NPVs at the 18% discount rate.
c. Are there any circumstances in which the 18% discount rate would give the correct NPVs? (Hint: Could upward bias be more severe for more-distant cash flows?)

Answer 1

Project & co 9000 , 6000 . Cooo Caste flows Ce ca es 9000 o o NPV (10 ) 3512 Discounted - 900 Coxy 4337 3304 3590 2434 2108 G – 9000 180 1800 1800 1800 1800 – – – – – 9000 Discuted - 9800 1525 -525.4 perpetuity 1800 - 10.000 - 8474 0018 (1:18 ) & True NP VS F e 2108 Ga – 52504 NPVs at 18% I Discount Rate we have to reduce Cash flows by 80% and then Discount them at 100% to Calculate True NPVs. So, co c. c. ₂ Cu es -9000 6.92 0.92 0.92x (actual) x 6ooo x5ooo - 9000 = 5520 4600 36800 4000 Disconto - 9000 Discounted o - 9000 5018 3801 2764 o NPVF = 2583

e C, C, -9000 1800 Cactual 1800 0.92 1800 X 0.92 X0.92 9000 1656 1656 1656 perpetuity So 1656 - 16560 a 15054 ool (101) 15054 - 9000 - 6054.54 NPVG - ? ? ? ? ? ? c) upward bias is overestimation, of cash flows. clearly, in case (6) where NPV was calculated at 18% the NPVE 2108 and NPUG - 525. These both values are lesser than project's True NPVS i.e. NPV - 2583 NPVG - 6054 So, when Cash flows will higher, 18% rate will give NPVS similar to NPVs in case (a) ? ? ?