Question

1. Cash flow

Suppose you will need to invest 20,000 in a project. You won’t have any income for the first 4 years. Starting from year 5, you will receive 9,000 each year for the next 5 years. Your required rate of return is 10%. Would you take this project or not? Why?

Answer 1

Evaluation of Investment proposal using NPV Decision Rule

Present value of future cash flows

Present value of future cash flows = CF5/(1 + r)⁴ + CF6/(1 + r)⁶ + CF7/(1 + r)⁷ + CF8/(1 + r)⁸ + CF9/(1 + r)⁹

= [$9,000/(1 + 0.10)⁵] + [$9,000/(1 + 0.10)⁶] + [$9,000/(1 + 0.10)⁷] + [$9,000/(1 + 0.10)⁸] + [$9,000/(1 + 0.10)⁹]

= [$9,000/1.610510] + [$9,000/1.771561] + [$9,000/1.948717] + [$9,000/2.143589] + [$9,000/2.357948]

= $5,588.29 + $5,080.27 + $4,618.42 + $4,198.57 + $3,816.88

= $23,302.43

Initial Investment Cost

Initial Investment Cost = $20,000 [Given]

Net Present Value (NPV) of the Project

Net Present Value (NPV) of the Project = Present Value of future cash flows – Initial Investment Cost

= $23,302.43 - $20,000

= $3,302.43

Decision to accept or reject the project

As per NPV Decision Rule, the Project should be accepted only if the NPV is Positive, else, Reject the Project. Here, the NPV of the Project is Positive $3,302.43, therefore, the Project should be accepted.