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 Happy Dog Soap Company is evaluating a proposed capital budgeting project (project Beta) that will require an initial investment of $3,000,000. The project is expected to generate the following net cash flows:

Year	Cash Flow
Year 1	$300,000
Year 2	$475,000
Year 3	$400,000
Year 4	$400,000

Happy Dog Soap Company’s weighted average cost of capital is 8%, and project Beta has the same risk as the firm’s average project. Based on the cash flows, what is project Beta’s NPV?

-$1,703,441

-$1,403,441

-$1,958,957

-$2,044,129

Making the accept or reject decision

Happy Dog Soap Company’s decision to accept or reject project Beta is independent of its decisions on other projects. If the firm follows the NPV method, it should   project Beta.

Suppose your boss has asked you to analyze two mutually exclusive projects—project A and project B. Both projects require the same investment amount, and the sum of cash inflows of Project A is larger than the sum of cash inflows of project B. A coworker told you that you don’t need to do an NPV analysis of the projects because you already know that project A will have a larger NPV than project B. Do you agree with your coworker’s statement?

No, the NPV calculation is based on percentage returns, so the size of a project’s cash flows does not affect a project’s NPV.

Yes, project A will always have the largest NPV, because its cash inflows are greater than project B’s cash inflows.

No, the NPV calculation will take into account not only the projects’ cash inflows but also the timing of cash inflows and outflows. Consequently, project B could have a larger NPV than project A, even though project A has larger cash inflows.

Answer 1

Initial investment = 3000000 , Cost of capital = 8%

Year	1	2	3	4
Cash Flow	300000	475000	400000	400000

NPV of the project = - Initial investment + Sum of present value of cash flow for year 1 to year 4 discounted at cost of capital of 8%

NPV of the project = -3000000 + 300000 / (1 + 8%) + 475000 / (1 + 8%)² + 400000 / (1 + 8%)³ + 400000 / (1 + 8%)⁴

NPV of the project = - 3000000 + 277777.7777 + 407235.9396 + 317532.8964 + 294011.9411 = -1703441.4452 = -1703441 (rounded to nearest whole dollar)

Hence NPV of the project = -1703441

Answer: -1703441

It is given Happy dog;s decision is independent of decisions of other projects and also this project has negative NPV. Thus this project will result in decrease in value of firm and shareholders, Therefore project should be rejected

If the firm follows the NPV method, it should reject project Beta.

NPV of the project is calculated by taking the sum of present values of cash inflows and cash outflows of a project. It is not used to calculate return of a project. The project with higher net present value is accepted. Present value of a cash flow depends on amount of cash flow, timing of cash flow and discount rate used. Project A has higher total cash flows than project B, but based on timing of cash flows it may have lower NPV because larger cash inflows may have been received during later years of life of project A and Project B may have received larger cash inflow during early years of life of project.Similarly timing of cash outflows also affects NPV.

Hence we do not agree.

Answer No, the NPV calculation will take into account not only the project's cash inflows but also the timing of cash inflows and outflows. Consequently, project B could have a larger NPV than project A, even though project A has larger cash inflows