Question

2. Several companies, including Indigo River Packaging and White Mountain Banking, are considering project A, which is believed by all to have a level of risk that is equal to that of the average-risk project at Indigo River Packaging. Project A is a project that would require an initial investment of 6,149 dollars and then produce an expected cash flow of 10,964 dollars in 8 years. Project A has an internal rate of return of 7.5 percent. The weighted-average cost of capital for Indigo River Packaging is 8.8 percent and the weighted-average cost of capital for White Mountain Banking is 9.97 percent. What is the NPV that White Mountain Banking would compute for project A?

Answer 1

Solution:

Given:

Initial Investment Requirement of Project A = $ 6,149

An Expected Cash Flow of Project A = $ 10,964 in 8 Years

Project A’s IRR = 7.5 %

The Weighted-Average Cost of Capital (WACC) for Indigo River Packaging = 8.8 %

The Weighted-Average Cost of Capital (WACC) for White Mountain Banking = 9.97 %

To Calculate:

The NPV that White Mountain Banking would compute for Project A:

Process: Calculations:

Formula:

1. Net Present Value = Total Present Value of Cash Flow – Initial Investment

2. Present Value of Cash Flow = Cash Flow of the Year / (1 + Discount Rate / 100) ^Number of Respective Year

Step: 1 Calculation of Present Value of Cash Flow of Project A by White Mountain Banking:

We know that,

Present Value of Cash Flow = Cash Flow of the Year / (1 + Discount Rate / 100) ^Number of Respective Year

Here:

Cash Flow = $ 10,964

Discount Rate or WACC = 9.97 % (for White Mountain Banking)

Number of Years = 8 Years

Initial Investment = $ 6,149

On putting these values in the above formula, we get,

Present Value of Cash Flow = $ 10,964 / (1 + 9.97 / 100) ^8

Present Value of Cash Flow = $ 10,964 / (1 + 0.0997) ^8

Present Value of Cash Flow = $ 10,964 / (1.0997) ^8

Present Value of Cash Flow = $ 10,964 / (2.1389163509)

Present Value of Cash Flow = $ 10,964 / (2.1389163509)

Present Value of Cash Flow = $ 5125.96016 ≈ $ 5126

Present Value of Cash Flow = $ 5126

Step: 2 Computation of Net Present Value of Project A by White Mountain Banking:

We know that,

Net Present Value = Total Present Value of Cash Flow – Initial Investment

Here:

Total Present Value of Cash Flow = $ 5126

Initial Investment = $ 6149

On putting these values in the above formula, we get,

Net Present Value = $ 5126 - $ 6149

Net Present Value = - $ 1023

Net Present Value of Project A by White Mountain Banking = - $ 1023

Ans: The Net Present Value of Project A computed by White Mountain Banking = - $ 1023