Question

Corner Jewelers, Inc. recently analyzed the project whose cash flows are shown below. However, before the company decided to accept or reject the project, the Federal Reserve changed interest rates and therefore the firm's cost of capital (r). The Fed's action did not affect the forecasted cash flows. By how much did the change in the r affect the project's forecasted NPV? Note that a project's expected NPV can be negative, in which case it should be rejected.

Old r.	8.00%	New r.	11.25%
Year	0	1	2	3
Cash flows	−$1,000	$410	$410	$410

Answer 1

Solution :

NPV of the project at old rate of Cost of capital of 8 % = $ 56.61

NPV of the project at new rate of Cost of Capital of 11.25 % = - $ 2.42

Thus the Change in the project's forecasted NPV due to change in the rate of cost of capital is

= NPV at New Rate Less : NPV at Old Rate

= - $ 2.42 - $ 56.61

= - $ 59.03

Thus there is a decrease in the Project's forecasted NPV at the new rate by - $ 59.03 when compared to the NPV at the old rate.

The Project at the new rate of cost of capital should be rejected as its NPV is negative.

Please find the attached screenshot of the excel sheet containing the detailed calculation for the above solution.