ABC Inc. is evaluating an investment project that lasts for three years. The project has the cost of capital of 15% and requires an initial investment of $2 million. There is a 40% chance that the project would be successful and would generate annual free cash flows of $3 million per year during the next three years. There is a 60% chance that the project would be less successful and would generate only $2 million per year during the next three years. However, ABC recognizes that if the project is successful, it could invest $3 million at the end of the second year to expand the project and receive a free cash flow of $6 million at the end of third year. ABC estimates that the net project value (NPV) of the project without the option to expand and the NPV of the project with the option to expand would be closest to: OA. The NPV of the project without the option to expand is $2.57 million and the NPV of the project with the option to expand is $4.85 million OB. The NPV of the project without the option to expand is $3.48 million and the NPV of the project with the option to expand is $4.85 million OC. The NPV of the project without the option to expand is $3.48 million and the NPV of the project with the option to expand is $4.15 million OD. The NPV of the project without the option to expand is $2.57 million and the NPV of the project with the option to expand is $6.53 million
Net Present Value
Net present value is the most important concept of finance. It is used to evaluate the investment and financing decisions that involve cash flows occurring over multiple periods. The difference between the present value of cash inflow and cash outflow is termed as net present value (NPV). It is used for capital budgeting and investment planning. It is also used to compare similar investment alternatives.
Investment Decision
The term investment refers to allocating money with the intention of getting positive returns in the future period. For example, an asset would be acquired with the motive of generating income by selling the asset when there is a price increase.
Factors That Complicate Capital Investment Analysis
Capital investment analysis is a way of the budgeting process that companies and the government use to evaluate the profitability of the investment that has been done for the long term. This can include the evaluation of fixed assets such as machinery, equipment, etc.
Capital Budgeting
Capital budgeting is a decision-making process whereby long-term investments is evaluated and selected based on whether such investment is worth pursuing in future or not. It plays an important role in financial decision-making as it impacts the profitability of the business in the long term. The benefits of capital budgeting may be in the form of increased revenue or reduction in cost. The capital budgeting decisions include replacing or rebuilding of the fixed assets, addition of an asset. These long-term investment decisions involve a large number of funds and are irreversible because the market for the second-hand asset may be difficult to find and will have an effect over long-time spam. A right decision can yield favorable returns on the other hand a wrong decision may have an effect on the sustainability of the firm. Capital budgeting helps businesses to understand risks that are involved in undertaking capital investment. It also enables them to choose the option which generates the best return by applying the various capital budgeting techniques.
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