Suppose Green Caterpillar Garden Supplies Inc. is evaluating a proposed capital

Question

Suppose Green Caterpillar Garden Supplies Inc. is evaluating a proposed capital budgeting project (project Beta) that will require an initial investment of $2,500,000. The project is expected to generate the following net cash flows: Green Caterpillar Garden Supplies Inc.'s weighted average cost of capital is 7%, and project Beta has the same risk as the firm's average project. Based on the cash flows, what is project Beta's NPV? 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? 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. Yes, project A will always have the largest NPV, because its cash inflows are greater than project B's cash inflows.

Explanation / Answer

Answer (a) : Beta's NPV is -1111556

Answer (b) It should reject Project Beta.

Answer (c) 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.

Example: Project A and Project B Investment is 1000, Discount rate 7%, Project B cash flow for 4 years 800,100,200,100 totalling 1200, Project A Cash Flows for 4 years 0,0,0,1400 totalling 1400.

Project A

Project B

Year Cash Flows (A) PV Factor @ 7% (B) PV ofCash Flows (A*B) 0 -2500000 1 -2500000 1 325000 0.934579 303738 2 475000 0.873439 414884 3 400000 0.816298 326519 4 450000 0.762895 343303 Net Present Value -1111556

Related Questions

Navigate

• Browse (All)
• Browse S
• Subjects

---

---

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.