Question

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 Green Caterpillar Garden Supplies Inc. 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	$325,000
Year 2	$475,000
Year 3	$450,000
Year 4	$425,000

Green Caterpillar Garden Supplies Inc.’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)?

$1,202,774

$877,774

$1,352,774

$1,377,774

Making the accept or reject decision

Green Caterpillar Garden Supplies Inc.’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/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 profit of $0. A firm should reject any project with an NPV of $0, because the project is not profitable.

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 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

Present Value = Future value/ ((1+r)^t)
where r is weighted average cost of capital that is 8% and t is the time period in years.
Net present value (NPV) = initial investment + sum of present values of future cash flows.
PROJECT ALPHA
Year	0	1	2	3	4
cash flow	-500000	325000	475000	450000	425000
present value		300925.9	407235.9	357224.5	312387.7
NPV	877774.1
Based on the cash flows the NPV of project Alpha is $877774.
If the firm follows the NPV method, the firm should accept the
project because the NPV is positive.
The NPV is zero when the rate of return is more than the cost of capital in this example.
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 profit of $0. A firm should reject any project with an NPV of $0, because the project is not profitable.