Question

1. 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 Cute Camel Woodcraft Company is evaluating a proposed capital budgeting project (project Alpha) that will require an initial investment of $550,000. The project is expected to generate the following net cash flows:

Year	Cash Flow
Year 1	$375,000
Year 2	$450,000
Year 3	$450,000
Year 4	$400,000

Cute Camel Woodcraft Company’s weighted average cost of capital is 7%, 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)?

$1,039,208

$866,007

$995,908

$316,007

Making the accept or reject decision

Cute Camel Woodcraft 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?

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.

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.

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

The NPV is computed as shown below:

= Initial investment + Present value of future cash flows

Present value is computed as follows:

= Future value / (1 + r)ⁿ

So, the NPV is computed as follows:

= - $ 550,000 + $ 375,000 / 1.07 + $ 450,000 / 1.07² + 450,000 / 1.07³ + 400,000 / 1.07⁴

= $ 866,007 Approximately

Since the NPV is positive, hence the firm shall accept the project.

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 is the statement which best explains what it means when a project has an NPV of $0

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