# Project's Net Present Value of Cash Flows

1. A project has the following forecasted cash flows:

C0 C1 C2 C3

-100 +40 +60 +50

The estimated project beta is 1.5. The market return is 16 percent. The risk-free rate is 7 percent.

a. What is the opportunity cost of capital?

b. What is the project's net present value?

c. What are the certainty equivalent cash flows in each year?

d. With the information you have been given, is this project worthwhile or not?

https://brainmass.com/economics/uncertainty/projects-net-present-value-cash-flows-132745

#### Solution Preview

Some discussion of basics:

The investment decisions of a firm are generally known as the capital budgeting, or capital expenditure decisions. The firm's investment decisions would generally include expansion, acquisition, modernization and replacement of the long-term assets. Sale of a division or business (divestment) is also as an investment decision.

Criteria of selection of Capital Budgeting project:

It should maximize the shareholders' wealth.

It should consider all cash flows to determine the true profitability of the project.

It should provide for an objective and unambiguous way of separating good projects from bad projects.

It should help ranking of projects according to their true profitability.

It should recognize the fact that bigger cash flows are preferable to smaller ones and early cash flows are preferable to later ones.

It should help to choose among mutually exclusive projects that project which maximizes the shareholders' wealth.

It should be a criterion, which is applicable to any conceivable investment project independent of others.

(Pandey, I.M.)

Concept of Risk

Yes we incorporate risk in the capital budgeting.

Risk exists because of the inability of the decision-maker to make perfect forecasts. In formal terms, the risk associated with an investment may be defined as the variability that is likely to occur in the future ...

#### Solution Summary

The project's net present value is determined.

Capital Budgeting: A Project's Net Present Value

Part 1

a. Consider the project with the following expected cash flows:

Year Cash Flow

0 - $550,000

1 $90,000

2 $100,000

3 $450,000

- If the discount rate is 0%, what is the project's net present value?

- If the discount rate is 4%, what is the project's net present value?

- If the discount rate is 8%, what is the project's net present value?

- If the discount rate is 10%, what is the project's net present value?

- What is this project's internal rate of return?

Now draw (for yourself) a chart where the discount rate is on the horizontal axis (the "x" axis) and the net present value on the vertical axis (the Y axis). Plot the net present value of the project as a function of the discount rate by dots for the four discount rates. connect the four points using a free hand 'smooth' curve. The curve intersects the horizontal line at a particular discount rate. What is this discount rate at which the graph intersects the horizontal axis?

b. Consider a project with the expected cash flows:

Year Cash Flow

0 - $315,000

1 +71,000

2 +150,000

3 +$150,000

- What is this project's internal rate of return?

- If the discount rate is 0%, what is this project's net present value?

- If the discount rate is 4%, what is this project's net present value?

- If the discount rate is 8%, what is this project's net present value?

- If the discount rate is 12%, what is this project's net present value?

Now draw (for yourself) a chart where the discount rate is on the horizontal axis (the "x" axis) and the net present value on the vertical axis (the Y axis). Plot the net present value of the project as a function of the discount rate by dots for the four discount rates. connect the four points using a free hand 'smooth' curve. The curve intersects the horizontal line at a particular discount rate. What is this discount rate at which the graph intersects the horizontal axis?

c. A project requiring a $3.3 million investment has a profitability index of 0.96. What is its net present value? (Remember: Profitability Index is defined as Present Value of the proceeds divided by the initial investment)

Part 2

Read the article linked below. Which method do you think is the better one for making capital budgeting decisions - IRR or NPV?