Question

Evaluating cash flows with the NPV method 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 Happy Dog Soap Company 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 Year 1 $350,000 Year 2 $475,000 Year 3 $425,000 Year 4 $475,000

Happy Dog Soap Company’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)?

$978,981 $1,201,288 $1,326,288 $851,288

Making the accept or reject decision

Happy Dog Soap Company’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. Which of the following statements best explains what it means when a project has an NPV of $0?

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. 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. 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.

Answer 1

Net present value can be solved using a financial calculator. The steps to solve on the financial calculator:

• Press the CF button.
• CF0= -$600,000. Indicate the initial cash flow by a negative sign since it is a cash outflow.  
• Cash flow for each year should be entered.
• Press Enter and down arrow after inputting each cash flow.
• After entering the last cash flow cash flow, press the NPV button and enter the weighted average cost of capital of 7%.
• Press enter after that. Press the down arrow and CPT buttons to get the net present value.  

Net present value at 7% weighted average cost of capital is $851,288.02.

If the firm follows the NPV method, it should accept the project since it generates a positive net present value.

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.

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