Question

2. Net present value (NPV)

The capital budgeting process is comprehensive and is based on certain assumptions, models, and benchmarks. This process often begins with a project analysis. Generally, the first step in a capital budgeting project analysis—which occurs before any evaluation method is applied—involves estimating the project’s expected cash flows   .

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 Lumbering Ox Truckmakers 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	$300,000
Year 2	$475,000
Year 3	$500,000
Year 4	$450,000

Lumbering Ox Truckmakers’s weighted average cost of capital is 9%, 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)? (Note: Do not round your intermediate calculations.)

$1,229,910

$1,279,910

$779,910

$1,379,910

Making the accept or reject decision

Lumbering Ox Truckmakers’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.

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 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.

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.

Answer 1

Answer 1:

Correct answer is:

$779,910

Explanation:

NPV is calculated as below:

As such option C is correct and other options A, B and D are incorrect.

Answer 2:

Correct answer is:

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.

Explanation:

We can take an example to illustrate this:

Consider two projects:

Project A has cash flow of $1000 in year 1 and Project B has cash flow of $1400 in year 4. Cost of capital is 15%

Now obviously it appears that Project B has larger cash flow than project A.

But when we calculate and compare PV, we find:

PV of cash flow of project A = 1000 * 1/ (1 + 15%) = $870

PV of cash flow of project B = 1400 * 1/ (1 + 15%) ⁴ = $800

Now we find although project B has larger cash flow, on present value terms Project A's cash flow has higher present value.

Hence option B is correct and other options A and C are incorrect.