What is the appropriate decision rule for a firm considering undertaking a capital project? Give a...

What is the appropriate decision rule for a firm considering undertaking a capital project? Give a real life example.

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Expert Solution

The appropriate decision rule is to calculate NPV using discount rate as WACC at target debt equity ratio. The NPV which is present value of all future cash flowws minus the initila invetsment should be greater than 0. Only then can it increase the value of the firm. IF NPV<0 it will eat away the value of the firm.
NPV = Cash flows/(!+WACC)^t - Initial Investment

A plabe is to be chosen by an airlines company which has a life of 10 years, will cost $132 million and will produce net cash flows of $24 million per year. Shao plans to serve the route for only 10 years. Inflation in operating costs, airplane costs, and fares is expected to be zero, and the company's cost of capital is 8%.

	Plan B	A	B	C	D	E	F	G	H	I	J	K
1	Year	0	1	2	3	4	5	6	7	8	9	10
2	Initial Investment	-132
3	Nt cash flows		24	24	24	24	24	24	24	24	24	24
4	Cost of Capital	8%
	NPV	29.04	NPV(A4,B3:K3)

Since NPV is positive and it adds value to the firm the Plane should be bought.

Best of Luck. God Bless

jeff jeffy answered 1 year ago

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