(5 points) The following five projects are under consideration by the management

Question

(5 points) The following five projects are under consideration by the management team at your company, Acme Widgets Incorporated. As Chief Financial Officer, you must decide which project to recommend to the board of directors for approval. Using NPV methodology, rank the projects from most to least desirable, and inform the board if there are any projects that should be avoided, and if so, why?

Project 1: Requires an initial cash expenditure of $50,000, has a 9.5% cost of capital, and will return 6 years of income flow in the amount of $10,000 each year.





Project 2: Will require an initial outlay of $50,000, has a 9.5% cost of capital, will return nothing for 5 years, but in the sixth year will return a lump sum payment of $75,000.





Project 3: Requires an investment of $50,000 and returns $10,000 per year for ten years. The cost of equity capital in this case is 9.5%.





Project 4: Requires a $50,000 initial outlay, with capital costs running at 9.5%. This project will generate a cash flow of $25,000 for each of the next 3 years.





Project 5: An initial investment of $50,000 must be made. There is an 9.5% cost of capital to the firm, producing an income stream of $12,000 for the next 5 years, and $7,000 for five more years thereafter.

Explanation / Answer

Each cash inflow/outflow is discounted back to its present value (PV). Then they are summed. Therefore NPV is the sum of all terms, r(t)/(1+i)^t-r0 where t - the time of the cash flow i - the discount rate (the rate of return that could be earned on an investment in the financial markets with similar risk.); the opportunity cost of capital Rt - the net cash flow (the amount of cash, inflow minus outflow) at time t. For educational purposes, R0 is commonly placed to the left of the sum to emphasize its role as (minus) the investment. npv in decision making : if NPV > 0 the investment would add value to the firm the project may be accepted NPV < 0 the investment would subtract value from the firm the project should be rejected NPV = 0 the investment would neither gain nor lose value for the firm We should be indifferent in the decision whether to accept or reject the project. This project adds no monetary value. Decision should be based on other criteria, e.g. strategic positioning or other factors not explicitly included in the calculation. 1.npv= -50000+1 0000/(1+.95)^t where t=1,2,3,...6 2.npv=-50000+750000/(1+.95)^5 3.npv=-50000+10000/(1+.95)^t where t=1,2,....10 similarly for other cases the one with the maximum positive value will be accepted

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