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Chapter 26: Q23RQ (page 1464)

What is the decision rule for NPV?

Short Answer

Expert verified

Net present value (NPV) can be calculated by taking the sum of the discounted cash flows and subtracting it from the initial investment. The discounted cash flows are determined using the discounting factor and the current value. The investment project should permit it if the NPV is positive; however, if it is negative, the investment project should not permit it.

Step by step solution

01

Definition

Net present value comes after subtracting the total current value of all future cash flows from initial investment. It is employed for investment decision-making and capital budgeting purposes.

02

Advantages of NPV

The advantage of the net present value method is that this method considers the fact of the time value of money. A further period of capital expenditure is constantly added to the cash flows to reduce them.

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Most popular questions from this chapter

Calculate the present value of the following future cash flows, rounding all calculations to the nearest dollar.

11. \(5,000 received in three years with interest of 10%

12. \)5,000 received in each of the following three years with interest of 10%

13. Payments of \(2,000, \)3,000, and $4,000 received in years 1, 2, and 3, respectively, with interest of 7%

Cornell Company is considering a project with an initial investment of \(596,500 that is expected to produce cash inflows of \)125,000 for nine years. Cornell’s required rate of return is 12%.

14. What is the NPV of the project?

15. What is the IRR of the project?

16. Is this an acceptable project for Cornell?

Hayes Company is considering two capital investments. Both investments have an initial cost of \(10,000,000 and total net cash inflows of \)17,000,000 over 10 years. Hayes requires a 12% rate of return on this type of investment. Expected net cash inflows are as follows:

Year

Plan Alpha

Plan Beta

1

\( 1,700,000

\) 1,700,000

2

1,700,000

2,300,000

3

1,700,000

2,900,000

4

1,700,000

2,300,000

5

1,700,000

1,700,000

6

1,700,000

1,600,000

7

1,700,000

1,200,000

8

1,700,000

800,000

9

1,700,000

400,000

10

1,700,000

2,100,000

Total

\( 17,000,000

\) 17,000,000

Requirements

  1. Use Excel to compute the NPV and IRR of the two plans. Which plan, if any, should the company pursue?

  2. Explain the relationship between NPV and IRR. Based on this relationship and the company’s required rate of return, are your answers as expected in Requirement 1? Why or why not?

  3. After further negotiating, the company can now invest with an initial cost of $9,500,000 for both plans. Recalculate the NPV and IRR. Which plan, if any, should the company pursue?

Spencer Wilkes is the marketing manager at Darby Company. Last year, Spencer recommended the company approve a capital investment project for the addition of a new product line. Spencer’s recommendation included predicted cash inflows for five years from the sales of the new product line. Darby Company has been selling the new products for almost one year. The company has a policy of conducting annual post audits on capital investments, and Spencer is concerned about the one-year post-audit because sales in the first year have been lower than he estimated. However, sales have been increasing for the last couple of months, and Spencer expects that by the end of the second year, actual sales will exceed his estimates for the first two years combined.

Spencer wants to shift some sales from the second year of the project into the first year. Doing so will make it appear that his cash flow predictions were accurate. With accurate estimates, he will be able to avoid a poor performance evaluation. Spencer has discussed his plan with a couple of key sales representatives, urging them to report sales in the current month that will not be shipped until a later month. Spencer has justified this course of action by explaining that there will be no effect on the annual financial statements because the project year does not coincide with the fiscal year––by the time the accounting year ends, the sales will have actually occurred.

Requirements

1. What is the fundamental ethical issue? Who are the affected parties?

2. If you were a sales representative at Darby Company, how would you respond to Spencer’s request? Why?

3. If you were Spencer’s manager and you discovered his plan, how would you respond?

4. Are there other courses of action Spencer could take?

What is the payback method of analyzing capital investments?

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