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 Cold Goose Metal Works Inc. is evaluating a proposed capital budgeting project (project Alpha) that will require an initial investment of $500,000. The project is expected to generate the following net cash flows:

Year	Cash Flow
Year 1	$275,000
Year 2	$400,000
Year 3	$475,000
Year 4	$500,000

Cold Goose Metal Works Inc.s weighted average cost of capital is 10%, and project Alpha has the same risk as the firms average project. Based on the cash flows, what is project Alphas net present value (NPV)?

a) $1,253,960

b) $1,178,960

c) $778,960

d) $1,278,960

Making the accept or reject decision

Cold Goose Metal Works Inc.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 (ACCEPT OR REJECT?) project Alpha.

Which of the following statements best explains what it means when a project has an NPV of $0?

a) When a project has an NPV of $0, the project is earning a rate of return less than the projects weighted average cost of capital. Its OK to accept the project, as long as the projects profit is positive.

b) When a project has an NPV of $0, 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.

c) When a project has an NPV of $0, the project is earning a rate of return equal to the projects weighted average cost of capital. Its OK to accept a project with an NPV of $0, because the project is earning the required minimum rate of return.

Part 2

The internal rate of return (IRR) refers to the compound annual rate of return that a project generates based on its up-front cost and subsequent cash flows. Consider the case of Purple Whale Foodstuffs Inc.:

Purple Whale Foodstuffs Inc. is evaluating a proposed capital budgeting project (project Sigma) that will require an initial investment of $750,000.

Purple Whale Foodstuffs Inc. has been basing capital budgeting decisions on a projects NPV; however, its new CFO wants to start using the IRR method for capital budgeting decisions. The CFO says that the IRR is a better method because returns in percentage form are easier to understand and compare to required returns. Purple Whale Foodstuffs Inc.s WACC is 10%, and project Sigma has the same risk as the firms average project.

The project is expected to generate the following net cash flows:

Year	Cash Flow
Year 1	$350,000
Year 2	$475,000
Year 3	$400,000
Year 4	$475,000

Which of the following is the correct calculation of project Sigmas IRR?

a) 45.10%

b) 43.05%

c) 38.95%

d) 41.00%

If this is an independent project, the IRR method states that the firm should (REJECT OR ACCEPT SIGMA?) .

If the projects cost of capital were to increase, how would that affect the IRR?

a) The IRR would decrease.

b)The IRR would not change.

c) The IRR would increase.