In: Finance
Suppose Blue Hamster Manufacturing Inc. is evaluating a proposed capital budgeting project (project Alpha) that will require an initial investment of $600,000. The project is expected to generate the following net cash flows:
Year | Cash Flow |
1 | $275,000 |
2 | $500,000 |
3 | $425,000 |
4 | $450,000 |
1. Blue Hamster Manufacturing Inc.’s weighted average cost of capital is 7%, and project Alpha has the same risk as the firm’s average project. Based on the cash flows, what is project Alpha’s net present value (NPV)?
$183,958
$940,750
$901,552
$783,958
2. Blue Hamster Manufacturing Inc.’s decision to accept or reject project Alpha is independent of its decisions on other projects. If the firm follows the NPV method, it should ____
project Alpha.
Accept or Reject
3. Which of the following statements best explains what it means when a project has an NPV of $0?
A. When a project has an NPV of $0, the project is earning a profit of $0. A firm should reject any project with an NPV of $0, because the project is not profitable.
B. When a project has an NPV of $0, the project is earning a rate of return equal to the project’s weighted average cost of capital. It’s OK to accept a project with an NPV of $0, because the project is earning the required minimum rate of return.
C. When a project has an NPV of $0, the project is earning a rate of return less than the project’s weighted average cost of capital. It’s OK to accept the project, as long as the project’s profit is positive.
Question | Answer |
1 | $783,958 |
2 | ACCEPT |
Question 3: The correct choice is option "B' - When a project has an NPV of $0, the project is earning a rate of return equal to the project’s weighted average cost of capital. It’s OK to accept a project with an NPV of $0, because the project is earning the required minimum rate of return.
Explanation:
Year | Cash flow | 1+r | PVIF | PV |
- | - 600,000 | 1.07 | 1.0000 | - 600,000 |
1 | 275,000 | 0.9346 | 257,009 | |
2 | 500,000 | 0.8734 | 436,719 | |
3 | 425,000 | 0.8163 | 346,927 | |
4 | 450,000 | 0.7629 | 343,303 | |
NPV | 783,958 |
The project will be accepeted as its NPV is not negtaive.