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 Pheasant Pharmaceuticals 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	$300,000
Year 2	$450,000
Year 3	$425,000
Year 4	$500,000

Pheasant Pharmaceuticalss weighted average cost of capital is 9%, 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) $1,336,376

b) $961,832

c) $1,136,376

d) $836,376

Making the accept or reject decision

Pheasant Pharmaceuticalss 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.

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

1) 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.

2) 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.

3) 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.