Question

The table below provides the estimated end-of-year net cash flows that would be received from alternative projects Red and Blue for an investment of $200,000. Project Red Project Blue Year 1 $90,000 $40,000 Year 2 $70,000 $50,000 Year 3 $60,000 $60,000 Year 4 $40,000 $126,000 (a) Find the NPV of each project if the cost of capital is 7%. (b) In part (a), which project is better? (c) Find the NPV of each project if the cost of capital is 9%. (d) In part (c), which project is better?

Answer 1

a

Project Red
Discount rate	0.07
Year	0	1	2	3	4
Cash flow stream	-200000	90000	70000	60000	40000
Discounting factor	1	1.07	1.1449	1.225043	1.310796
Discounted cash flows project	-200000	84112.15	61140.71	48977.87	30515.808
NPV = Sum of discounted cash flows
NPV Project Red =	24746.54
Where
Discounting factor =	(1 + discount rate)^(Corresponding period in years)
Discounted Cashflow=	Cash flow stream/discounting factor
Project Blue
Discount rate	0.07
Year	0	1	2	3	4
Cash flow stream	-200000	40000	50000	60000	126000
Discounting factor	1	1.07	1.1449	1.225043	1.310796
Discounted cash flows project	-200000	37383.18	43671.94	48977.87	96124.797
NPV = Sum of discounted cash flows
NPV Project Blue =	26157.78
Where
Discounting factor =	(1 + discount rate)^(Corresponding period in years)
Discounted Cashflow=	Cash flow stream/discounting factor

b

Project Blue as it has higher NPV

c

Project Red
Discount rate	0.09
Year	0	1	2	3	4
Cash flow stream	-200000	90000	70000	60000	40000
Discounting factor	1	1.09	1.1881	1.295029	1.4115816
Discounted cash flows project	-200000	82568.81	58917.6	46331.01	28337.008
NPV = Sum of discounted cash flows
NPV Project Red =	16154.42
Where
Discounting factor =	(1 + discount rate)^(Corresponding period in years)
Discounted Cashflow=	Cash flow stream/discounting factor
Project Blue
Discount rate	0.09
Year	0	1	2	3	4
Cash flow stream	-200000	40000	50000	60000	126000
Discounting factor	1	1.09	1.1881	1.295029	1.4115816
Discounted cash flows project	-200000	36697.25	42084	46331.01	89261.577
NPV = Sum of discounted cash flows
NPV Project Blue =	14373.83
Where
Discounting factor =	(1 + discount rate)^(Corresponding period in years)
Discounted Cashflow=	Cash flow stream/discounting factor

d

Project red as it has higher NPV