Question

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 Green Caterpillar Garden Supplies Inc. is evaluating a proposed capital budgeting project (project Beta) that will require an initial investment of $3,000,000. The project is expected to generate the following net cash flows: Year Cash Flow Year 1 $275,000 Year 2 $425,000 Year 3 $400,000 Year 4 $425,000 Green Caterpillar Garden Supplies Inc.’s weighted average cost of capital is 10%, and project Beta has the same risk as the firm’s average project. Based on the cash flows, what is project Beta’s NPV? -$4,807,954 -$1,532,954 -$1,382,954 -$1,807,954 Making the accept or reject decision Green Caterpillar Garden Supplies Inc.’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. 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. Do you agree with your coworker’s statement? Yes, project A will always have the largest NPV, because its cash inflows are greater than project B’s cash inflows. 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. 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

NPV :
NPV = PV of Cash Inflows - PV of Cash Outflows
If NPV > 0 , Project can be accepted
NPV = 0 , Indifference point. Project can be accepted/ Rejected.
NPV < 0 , Project will be rejected.

Year	CF	PVF @10 %	Disc CF
0	$ -30,00,000.00	1.0000	$ -30,00,000.00
1	$     2,75,000.00	0.9091	$     2,50,000.00
2	$     4,25,000.00	0.8264	$     3,51,239.67
3	$     4,00,000.00	0.7513	$     3,00,525.92
4	$     4,25,000.00	0.6830	$     2,90,280.72
NPV			$ -18,07,953.69

Option D is correct.

Reject the project as it has -ve NPV.

We need to consider the required Ret based on Beta.

required ret = Risk Free Ret + Beta [ Market ret - Risk Free Ret ]

In case of Mutually exclusive Projects, We will selet the project with higher NPV ( NPV > 0 ).

NPV = PV of Cash Inflows - PV of Cash Outflows.

Thus eventhough Project A has higher CFs, it may end up with lesser NPV. As the timing of CFs is also important.

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.