Question

Suppose Green Caterpillar Garden Supplies Inc. is evaluating a proposed capital budgeting project (project Alpha) that will require an initial investment of $450,000. The project is expected to generate the following net cash flows:

Year	Cash Flow
Year 1	$350,000
Year 2	$425,000
Year 3	$500,000
Year 4	$400,000

1. 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)?

2. 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.

3. 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 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.

b. 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.

c. 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.

Answer 1

Solution

1) NPV

Year	Cash flows	PV Factor @8%	Present Value
1	3,50,000.00	0.9259	3,24,074.07
2	4,25,000.00	0.8573	3,64,369.00
3	5,00,000.00	0.7938	3,96,916.12
4	4,00,000.00	0.7350	2,94,011.94
		PV	13,79,371.13
		Investment	4,50,000.00
		NPV	9,29,371.13

2) Decision.

Since the project have a positive NPV, the project should be accepted.

3)

  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.

If you discount a cash flow with 8% and gets a $0 NPV, then the analysis indicates that the investment will earn a 8% real return.