Question

Net present value (NPV)

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 Pheasant Pharmaceuticals is evaluating a proposed capital budgeting project (project Beta) that will require an initial investment of $2,225,000. The project is expected to generate the following net cash flows:

Year	Cash Flow
Year 1	$275,000
Year 2	$475,000
Year 3	$450,000
Year 4	$450,000

Pheasant Pharmaceuticals’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?

A.) -$600,146

B.) $1,349,854

C.) -$875,146

D.) -$400,146

Making the accept or reject decision

Pheasant Pharmaceuticals’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.

A.) Accept

B.) Reject

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. Is your coworker’s statement valid?

A.) 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.

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

C.) 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

a). Calculating the NPV of the Project's cashflows:-

Year	Cash Flow of Project ($)	PV Factor @8%	Present Value of Project ($)
0	(2,225,000.00)	1.00000	(2,225,000.00)
1	275,000.00	0.92593	254,629.63
2	475,000.00	0.85734	407,235.94
3	450,000.00	0.79383	357,224.51
4	450,000.00	0.73503	330,763.43
			(875,146.49)

So, NPV of Project BEta is -$875,146

Option C

b). Pheasant Pharmaceuticals’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 Reject project Beta.

Option B

As the NPV of the Project Beta is negative.

c). Option C

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.

NPV takes into account time value of money and thus timing of cashinflows and outflows matters alot and not the sum of cash flows.