Question

Your boss, the chief financial officer (CFO) for Southern Textiles, has just handed you the estimated cash flows for two proposed projects. Project L involves adding a new item to the firm’s fabric line. It would take some time to build up the market for this product, so the cash inflows would increase over time. Project S involves an add-on to an existing line, and its cash flows would decrease over time. Both projects have 3-year lives because Southern is planning to introduce an entirely new fabric at that time.

   Here are the net cash flow estimates (in thousands of dollars):

   Expected Net Cash Flows      

Year   Project L   Project S

   0   $(100)   $(100)

   1   10   70

   2   60   50

   3   80   20

The CFO also made subjective risk assessments of each project, and he concluded that the projects both have risk characteristics that are similar to the firm’s average project. Southern’s required rate of return is 10%. You must now determine whether one or both of the projects should be accepted. Start by answering the following questions:

1. Define the term net present value (NPV). What is each project’s NPV?

2.What is the rationale behind the NPV method? According to NPV, which project or projects should be accepted if they are independent? Mutually exclusive?

3.Would the NPVs change if the required rate of return changed?

Answer 1

Requirement (1) - Net Present Value [NPV]

Project L

Year	Annual Net Cash Flows	Present Value factor at 10%	Present Value of Annual Net Cash Flows (in thousands of dollars)
1	10.00	0.909090909	$9.09
2	60.00	0.826446281	$49.59
3	80.00	0.751314801	$60.11
			$118.79

Net Present Value [NPV] = Present Value of cash Inflows – Initial Investment

= $118.79 – 100.00

= $ 18.79

Project L

Year	Annual Net Cash Flows	Present Value factor at 10%	Present Value of Annual Net Cash Flows (in thousands of dollars)
1	$70.00	0.909090909	$63.64
2	$50.00	0.826446281	$41.32
3	$20.00	0.751314801	$15.03
			$119.99

Net Present Value [NPV] = Present Value of cash Inflows – Initial Investment

= $119.99 – 100.00

= $ 19.99

Requirement (2) - Rationale behind the NPV method

- Net Present Value [NPV] method is the one of the most commonly used method for taking capital budgeting decisions with respect to the investment proposals.

- The NPV Indicates the value of the investment project or the net worth of the investments to the firm

- Net Present Value [NPV] is the difference between the total present value of the annual cash inflows and initial investment of the project proposal

- The project proposal is acceptable if the NPV is positive and else reject the project

- If the Projects are Independent, accept the project if the NPV is greater than Zero

- If the Projects are mutually exclusive, accept the projects with the Higher NPV

Requirement (3) – Change in NPV if the required rate of return changed

- If the Required rate of return is increased, the discounting factor will decrease, to that effect, the “NPV WILL DECREASE”

- If the Required rate of return is decreases, the discounting factor will Increase, to that effect, the “NPV WILL INCREASE”