Question

h 11: Assignment - The Basics of Capital Budgeting 1. Net present value (NPV) 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 Happy Dog Soap Company is evaluating a proposed capital budgeting project (project Beta) that will require an initial investment of $2,225,000. The project is expected to generate the following net cash flows: Year Cash Flow Year 1 Year 2 Year 3 Year 4 $325,000 $475,000 $400,000 $425,000 Happy Dog Soap Company's weighted average cost of capital is 8%, and project Beta has the same risk as the firm's average project. Based on th cash flows, what is project Beta's NPV? -$561,918 -$3,111,918 -$486,918 O $886,918

Answer 1

NPV is given by:

NPV = L Rt/(1 + i) ,t varies from 1 ton where Rt = Cash flow netted (Inflow - Outflow) during the period "t" i = Discount rate t = number of periods

SUM X fx =NPV(C1,C4:07)+C3 A DE Discount Rate 8% Year Project A 0 $22,25,000 1 $3,25,000 $4,75,000 $4,00,000 4. $4,25,000 IRR -11.23% NPV =NPV(C1, C4:07 )+ C3

09 @ fx =NPV(C1,C4:C7)+C3 D E в Discount Rate Year 0 1 с 8% Project A $22,25,000 $3,25,000 $4,75,000 $4,00,000 $4,25,000 -11.23% $8,86,917.55 2 3 4 - IRR NPV

Another way

SUM fx =D7/(1+$C$2)^D4 C D B Project A Discount Rate (r) 8% Nm+ in 1 0 22,25,000 3,25,000 years Cash-Outflows Cash-Inflows Net Cashflows (Inflow - Outflow) Discounted Cashflow = Net CF/ (1+r)^years -22,25,000 3,25,000 00 -22,25,000.00 = D7 /(1+ $C$2 ) D4

SUM ✓ fx I B Project A Discount Rate (r) I =SUM(C8:58) C D E F G 8 % 22,25,000 4,25,000 years Cash-Outflows Cash-Inflows Net Cashflows (Inflow - Outflow) Discounted Cashflow = Net CF/(1+r)^years Cummulative CF 3,25,000 3,25,000 4,75,000 4,75,000 4,00,000 4,00,000 -22,25,000 4,25,000 -22,25,000.00 3,12,387.69 3,00,925.93 4,07,235.94 3,00,926 7,08,162 3,17,532.90 10,25,695 13,38,082 NPV = sum of all discounted CF =SUM( 08:58)

C11 e fx =SUM(C8:68) E Project A Discount Rate (r) 8% O 1 2 3 4 22,25,000 3,25,000 4,75,000 4,25,000 years Cash-Outflows Cash-Inflows Net Cashflows (Inflow - Outflow) Discounted Cashflow = Net CF/(1+r)^years Cummulative CF 4,00,000 4,00,000 -22,25,000 3,25,000 4,75,000 4,25,000 -22,25,000.00 3,00,925.93 4,07,235.94 3,17,532.90 3,12,387.69 3,00,926 7,08,162 10,25,695 13,38,082 NPV = sum of all discounted CF -8,86,917.55

The firm should REJECT project Beta (Since NPV is negative)

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Correct option is Option 1 = No, the NPV calculation will take into account not only the project's cash inflows but also the timings of the cash inflows and outflows. Consequently, Project B could have larger NPV than Project A