10-9: Look back to the cash flows for projects F and G in 5-3. The cost of capit
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Question
10-9:Look back to the cash flows for projects F and G in 5-3. The cost of capital was assumed to be 10%. Assume that the forecasted cash flows for projects of this type are over-stated by 8% on average. That is, the forecasted for each cash flow from each project should be reduced by 8%. But a lazy financial manager, unwilling to take the time to argue with the project’s sponsors, instructs them to use a discount rate of 18%.
a. What are the project’s true NPVs?
b. What are the NPVs at the 18% discount rate?
c. Are there any circumstances in which the 18% discount rate would give the correct NPV’s (hint: Could upward bias be more severe for more-distant cash flows?)
Explanation / Answer
A) Project's true NPV: Let us assume that the annual cash flows are $5,000 for 5 years. (after deducting the 8% over statement of cash flow) and the discount rate is 10% then Present value of cash inflows = 3.791 x $5,000 So present value of cash inflows = $18,955 And let us assume that the initial investment in the 0th year is $16,000. Now the NPV = Present value of cash inflows - Present value of cash out flows NPV = $18,955 - 16,000 NPV = $2,955. B) NPV at 18% discount rate: Present value of cash inflows at 18% discount rate and 5 years period; Present value of cash inflows = 3.127 x $5,000 So present value of cash inflows = $15,635 Initial investment = $16,000 So NPV = Present value of cash inflows - Present value of cash out flows = $15,635 - $16,000 NPV = -$365 C) It is not a feasible way to increase the discount rate by 8% according to the increase in the cash flows (over state). See the increase in the discount rate will decrease the Net present value of the project if we increase the discount rate as in the above case. So here the cash flows only should be deducted based on the over statement. So the correct Net present value = $2,955.
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