1. Net present value (NPV)

Evaluating cash flows with the NPV method

The net present value (NPV) rule is considered one of the mostcommon and preferred criteria that generally lead to goodinvestment decisions.

Consider this case:

Suppose Happy Dog Soap Company is evaluating a proposed capitalbudgeting project (project Beta) that will require an initialinvestment of $3,000,000. The project is expected to generate thefollowing net cash flows:

Year	Cash Flow
Year 1	$300,000
Year 2	$475,000
Year 3	$400,000
Year 4	$400,000

Happy Dog Soap Company’s weighted average cost of capital is 8%,and project Beta has the same risk as the firm’s average project.Based on the cash flows, what is project Beta’s NPV?

-$1,703,441

-$1,403,441

-$1,958,957

-$2,044,129

Making the accept or reject decision

Happy Dog Soap Company’s decision to accept or reject projectBeta is independent of its decisions on other projects. If the firmfollows the NPV method, it should   project Beta.

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

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

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

No, the NPV calculation will take into account not only theprojects’ cash inflows but also the timing of cash inflows andoutflows. Consequently, project B could have a larger NPV thanproject A, even though project A has larger cash inflows.