1. 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 $3,000,000. The project is expected to generate the following net cash flows:
|
Year
|
Cash Flow
|
|
Year 1
|
$325,000
|
|
Year 2
|
$425,000
|
|
Year 3
|
$400,000a
|
|
Year 4
|
$425,000
|
Cold Goose Metal works Inc.'s weighted average cost of capital is 7%, and project Beta has the same risk as the firm's average project. Based on the cash flows, what is project Beta's NPV?
- $1,249,301
- $1,674,301
- $2,009,161
- $1,925,446
Blue Moose Home Builders has been basing capital budgeting decisions on a project's NPV; however, its new CFO wants to start using the IRR method for capital budgeting decisions. The CFO says that the IRR is a better method because percentages and returns are easier to understand and to compare to required returns. Blue Moose Home Builders's WACC is 9%, and project Delta has the same risk as the firm's average project.
The project is expected to generate the following net cash flows:
|
Year
|
Cash Flow
|
|
Year 1
|
$375,000
|
|
Year 2
|
$500,000
|
|
Year 3
|
$425,000
|
|
Year 4
|
$500,000
|
Which of the following is the correct calculation of project Delta's IRR?
If this is an independent project, the IRR method states that the firm should If the project's cost of capital were to increase, how would that affect the IRR?
- The IRR would increase.
- The IRR would not change.
- The IRR would decrease.