Suppose Lumbering Ox Truckmakers is evaluating a proposed capital budgeting proj

Question

Suppose Lumbering Ox Truckmakers is evaluating a proposed capital budgeting project (project Alpha) that wil require an initial investment of $550,000. The project is expected to generate the following net cash flows: Year Cash Flow Year 1 $350,000 Year 2 $500,000 Year 3 $450,000 Year 4 $450,000 Lumbering Ox Truckmakers's weighted average 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)? $924,459 O $1,424,459 O $1,109,351 $1,274,459 Making the accept or reject decision Lumbering Ox Truckmakers's decision to accept or reject project Alpha is independent of its decisions on other projects. If the firm follows the NPV method, it should project Alpha.

Explanation / Answer

Requirement 1:

Project Alpha

Year

Cash Flow

PV Factor Formula

PV Factor @ 7%

PV

0

($550,000)

1/(1+0.07)^0

1

($550,000.00)

1

$350,000

1/(1+0.07)^1

0.934579439

$327,102.80

2

$500,000

1/(1+0.07)^2

0.873438728

$436,719.36

3

$450,000

1/(1+0.07)^3

0.816297877

$367,334.04

4

$450,000

1/(1+0.07)^4

0.762895212

$343,302.85

NPV

$924,459.06

Net present value of project Alpha is $ 924,459

Hence option “1st : $ 924,459” is correct answer.

If the firm follows the NPV method, it should accept project Alpha.

Requirement: 2

Let’s use IRR method to compute IRR.

Let’s try with 26 %.

Project Sigma

Year

Cash Flow

PV Factor Formula

PV Factor @ 26 %

PV

0

($850,000)

1/(1+0.26)^0

1

($850,000.00)

1

$275,000

1/(1+0.26)^1

0.793650794

$218,253.97

2

$400,000

1/(1+0.26)^2

0.629881582

$251,952.63

3

$450,000

1/(1+0.26)^3

0.499906018

$224,957.71

4

$425,000

1/(1+0.26)^4

0.396750808

$168,619.09

NPV1

$13,783.40

As NPV is positive let’s try with 27 %.

Project Sigma

Year

Cash Flow

PV Factor Formula

PV Factor @ 27 %

PV

0

($850,000)

1/(1+0.27)^0

1

($850,000.00)

1

$275,000

1/(1+0.27)^1

0.787401575

$216,535.43

2

$400,000

1/(1+0.27)^2

0.62000124

$248,000.50

3

$450,000

1/(1+0.27)^3

0.488189953

$219,685.48

4

$425,000

1/(1+0.27)^4

0.384401538

$163,370.65

NPV2

($2,407.94)

IRR = 26 % +NPV 1 (R2 – R1) % / (NPV1 – NPV2)

         = 26 % +$ 13,783.40 (27 – 26) % /($ 13,783.40 – (–2,407.94)

         = 26 % + $ 137.8340 /($ 13,783.40 + $ 2,407.94)

         = 26 % + $ 137.8340/$16,191.34

         = 26 % + 0.008512823

         = 26 % +0.85%

         =26.85 %

Hence option “4th: 26.85 %” is correct answer.

IRR method states that the firm should accept the project Sigma as rate of return is greater than WACC of firm.

IRR rule describes that for mutually exclusive projects, the project with the highest IRR should be selected, provided IRR should be greater than cost of capital. When the IRR exceeds the cost of capital, the net cash flow to investor is also higher.

Hence option “2nd is correct answer”.

Project Alpha

Year

Cash Flow

PV Factor Formula

PV Factor @ 7%

PV

0

($550,000)

1/(1+0.07)^0

1

($550,000.00)

1

$350,000

1/(1+0.07)^1

0.934579439

$327,102.80

2

$500,000

1/(1+0.07)^2

0.873438728

$436,719.36

3

$450,000

1/(1+0.07)^3

0.816297877

$367,334.04

4

$450,000

1/(1+0.07)^4

0.762895212

$343,302.85

NPV

$924,459.06

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