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 Happy Dog Soap Company 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	$425,000
Year 3	$425,000
Year 4	$400,000

Happy Dog Soap Company’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)?

$819,834

$1,169,834

$942,809

$1,219,834

Making the accept or reject decision

Happy Dog Soap 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 1) ACCEPT 2)REJECT 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 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.

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.

Answer 1

What is project Alpha’s net present value (NPV)?

Answer: $819,834

Happy Dog Soap 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?

Answer: 1) ACCEPT project Alpha.

Which of the following statements best explains what it means when a project has an NPV of $0?

Answer: 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.

                                   

Workings

Formula for calculating Net Present Value is as follows

NPV     = Present Value of Future cash flows – Initial investment

Initial investment           = $ 500,000

Present value of future cash flows, we need to calculate cash flow for 4 years. Present value of a cash flow can be found out using the following formula.

Where,

R = required rate of return = 8% (weighted average cost of capital)

N = number of years

Present value of future cash flows calculation

Year	Cash Flow	Workings for present Value	Present Value
1	$350,000	=$350,000 ÷(1.08)1	$324,074.07
2	$425,000	=$425,000 ÷(1.08)2	$364,369.00
3	$425,000	=$425,000 ÷(1.08)3	$337,378.70
4	$400,000	=$400,000 ÷(1.08)4	$294,011.94
Present value of future cash flows	$1,319,833.71

NPV Calculation

NPV     = Present Value of Future cash flows – Initial investment

                = $1,319,833.72 ̶ $500,000

            = $819,833.72

            = $819,834

Note: since NPV is greater than 0 project alpha should be accepted, since it is generating return in excess of required rate of return.