EValuating cash Tlows with the NPV method The net present value (NPV) rule is co
ID: 2786894 • Letter: E
Question
EValuating cash Tlows 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 Black Sheep Broadcasting Company is evaluating a proposed capital budgeting project (project Beta) that will require an initial investment of $3,225,000. The project is expected to generate the following net cash flows: Year Cash Flow Year 1 $300,000 Year 2 $500,000 Year 3 $425,000 Year 4 $500,000 Black Sheep Broadcasting 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? $1,411,341 O -$2,176,391 O -$1,813,659 O-$2,085,708Explanation / Answer
Initial cash flow = $3,225,000
cash inflow year 1 = $300,000
cash inflow year 2 = $500,000
cash inflow year 3 = $425,000
cash inflow year 4 = $500,000
NPV = initial cash outflow + present value of future cash flows
NPV = -3225000 + 300000/1.08 + 500000/1.082 + 425000/1.083 + 500000/1.084
NPV = -3225000 + 277777.78 + 428669.41 + 337378.70 + 367514.93
NPV = -$1,813,659
If the firm follows the NPV method, the firm should reject the project as the NPV is negative.
The second bullet point which states that the NPV 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.
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