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 Beta) that will require an initial investment of $2,225,000. The project is expected to generate the following net cash flows: Year Cash Flow Year 1 $375,000 Year 2 $500,000 Year 3 $475,000 Year 4 $500,000 Cold Goose Metal Works Inc.’s weighted average cost of capital is 10%, and project Beta has the same risk as the firm’s average project. Based on the cash flows, what is project Beta’s NPV? -$2,997,487 -$297,487 -$888,360 -$772,487 Making the accept or reject decision Cold Goose Metal Works Inc.’s decision to accept or reject project Beta is independent of its decisions on other projects. If the firm follows the NPV method, it should (reject or accept) project Beta. Suppose your boss has asked you to analyze two mutually exclusive projects—project A and project B. Both projects require the same investment amount, and the sum of cash inflows of Project A is larger than the sum of cash inflows of project B. A coworker told you that you don’t need to do an NPV analysis of the projects because you already know that project A will have a larger NPV than project B. Do you agree with your coworker’s statement? No, the NPV calculation 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. No, the NPV calculation is based on percentage returns, so the size of a project’s cash flows does not affect a project’s NPV. Yes, project A will always have the largest NPV, because its cash inflows are greater than project B’s cash inflows.

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 Beta) that will require an initial investment of $2,225,000. The project is expected to generate the following net cash flows: Year Cash Flow Year 1 $375,000 Year 2 $500,000 Year 3 $475,000 Year 4 $500,000 Cold Goose Metal Works Inc.’s weighted average cost of capital is 10%, and project Beta has the same risk as the firm’s average project. Based on the cash flows, what is project Beta’s NPV? -$2,997,487 -$297,487 -$888,360 -$772,487 Making the accept or reject decision Cold Goose Metal Works Inc.’s decision to accept or reject project Beta is independent of its decisions on other projects. If the firm follows the NPV method, it should (reject or accept) project Beta. Suppose your boss has asked you to analyze two mutually exclusive projects—project A and project B. Both projects require the same investment amount, and the sum of cash inflows of Project A is larger than the sum of cash inflows of project B. A coworker told you that you don’t need to do an NPV analysis of the projects because you already know that project A will have a larger NPV than project B. Do you agree with your coworker’s statement? No, the NPV calculation 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. No, the NPV calculation is based on percentage returns, so the size of a project’s cash flows does not affect a project’s NPV. Yes, project A will always have the largest NPV, because its cash inflows are greater than project B’s cash inflows.

Managerial Accounting

15th Edition

ISBN:9781337912020

Author:Carl Warren, Ph.d. Cma William B. Tayler

Publisher:Carl Warren, Ph.d. Cma William B. Tayler

Chapter12: Capital Investment Analysis

Section: Chapter Questions

Problem 2PA

See similar textbooks

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 Beta) that will require an initial investment of $2,225,000. The project is expected to generate the following net cash flows:

Year	Cash Flow
Year 1	$375,000
Year 2	$500,000
Year 3	$475,000
Year 4	$500,000

Cold Goose Metal Works Inc.’s weighted average cost of capital is 10%, and project Beta has the same risk as the firm’s average project. Based on the cash flows, what is project Beta’s NPV?

-$2,997,487

-$297,487

-$888,360

-$772,487

Making the accept or reject decision

Cold Goose Metal Works Inc.’s decision to accept or reject project Beta is independent of its decisions on other projects. If the firm follows the NPV method, it should (reject or accept) project Beta.

Suppose your boss has asked you to analyze two mutually exclusive projects—project A and project B. Both projects require the same investment amount, and the sum of cash inflows of Project A is larger than the sum of cash inflows of project B. A coworker told you that you don’t need to do an NPV analysis of the projects because you already know that project A will have a larger NPV than project B. Do you agree with your coworker’s statement?

No, the NPV calculation 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.

No, the NPV calculation is based on percentage returns, so the size of a project’s cash flows does not affect a project’s NPV.

Yes, project A will always have the largest NPV, because its cash inflows are greater than project B’s cash inflows.

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