2. Net present value (NPV) AaAa Evaluating cash flows with the NPV method The ne

Question

2. Net present value (NPV) AaAa Evaluating cash flows with the NPV method The net present valve (NP) rule is considered one of the most common and preferred criteria that generally lead to good investment decisions. Consider this case: Suppose Pheasant Pharmaceuticals is evaluating a proposed capital budgeting project (project Alpha) that will require an initial investment of $450,000. The project is expected to generate the following net cash flows: Year Cash Flow Year 1 $325,000 Year 2 $500,000 Year 3 $400,000 Year 4 $475,000 Pheasant Pharmaceuticals's 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)7 O $979,352 O $1,454,352 O $1,379,352 O $1,175,222 Making the accept or reject decision Pheasant Pharmaceuticals's decision to accept or reject project Alpha is independent of its decisions projects. If the firm follows the NPV method, it should on other project Alpha. Which of the following statements best explains what it means when a project has an NPV of $0? O When a project has an NPV of $o, 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. O When a project has an NPV of $0. the project is earning a rate of return equal to the project's cost of capital. It's OK to accept a project with an NPV of so, because the project is earning the required minimum rate cf return. O When a project has an NPV of s0, the project is earning a rate of return less than the project's cost of capital. It's OK to accept the project, as long as the project's profit is positive.

Explanation / Answer

Solution :

a)Present Value of cash Inflows = $ 325000 * PVIF(7%,1) + $ 500000 * PVIF(7%,2) + $ 400000 * PVIF(7%,3) +

$ 475000 * PVIF(7%,4)

= ($325000* 0.9345) + ($500000 * 0.8734) + ($400000 * 0.8163) + ($475000 * 0.7629)

= $ 1429352

Present Value of Cash Outflow = $ 450000

NPV = Present Value of cash Inflows - Present Value of Cash Outflow

= $ 1429352 - $ 450000

= $ 979352

b)As NPV is positive, the project should be accepted.

c)When a project has NPV = $0, the project is earning a rate of return equal to the project's cost of capital. It's ok to accept a project with NPV of $0 because the project is earning the required rate of return.

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