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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?

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.