2. Net present value (NPV) The capital budgeting process is comprehensive and is

Question

2. Net present value (NPV) The capital budgeting process is comprehensive and is based on certain assumptions, or models and benchmarks that a company follows. This process often begins with project analysis. Generally, the first step in project analysis before using any evaluation method is to estimate theproject's expected cash flows revenues from all new projects company's net income project's expected cash flows Evaluating cash flows 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 Cute Camel Woodcraft Company 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 $300,000 Year 2 $425,000 Year 3 $400,000 Year 4 $500,000 Cute Camel woodcraft Company's weighted average cost of capital is 8%, and project Beta has the same risk as the firm's average project. Based on the cash flows, what is project Beta's NPV? O -$2,007,366 O -$4,672,805 O -$1,247,805 O -$1,672,805

Explanation / Answer

1) The first step in project analysis before using any evaluation method is to estimate the project's expected cash flows.

2) Present value of an amount is calculation as -

PV = Cash Flow / (1 + r)n

where, r = rate of interest or cost of capital, n = no. of years

NPV = (-)Initial investment + Present value of cash inflows

or, NPV = (-)$3,000,000 + [ $300,000 / (1 + 0.08)1 ] + [ $425,000 / (1 + 0.08)2 ] + [ $400,000 / (1 + 0.08)3 ] + [ $500,000 / (1 + 0.08)4 ]

or, NPV = (-)$1,672,805

3) If the firm follows NPV method, it should reject project beta.

4) No, the NPV calculation will take into account not only the project's 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. (Third option)

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