Chapter 9, Problem 4PROB

Summary Introduction

To make capital budgeting decision, it is required that the asset and or projects are properly evaluated. This is done as follows:

Estimated the cash flows which is expected to be generated from the project or asset

Evaluate the riskiness of the project and determine an appropriate discount rate specific for the project

Determine the present value of all the expected cash flows, this is done by using the below equation

$\begin{array}{c}\text{PV of CF}=\frac{{\widehat{CF}}_1}{{\left(1+r\right)}^1}+\frac{{\widehat{CF}}_2}{{\left(1+r\right)}^2}+\mathrm{.......}+\frac{\widehat{C{F}_n}}{{\left(1+r\right)}^n}\\ ={\displaystyle \sum _{t=1}^n\frac{\widehat{C{F}_t}}{{\left(1+r\right)}^t}\mathrm{\hspace{1em}\hspace{1em} \hspace{1em}}}\end{array}$

Here,

Expected net cash flow in Period t is “$\widehat{C{F}_t}$”

Required rate of return is “r”

Now, compare the present value of future expected cash flows with the cost of the project. If the present value of cash inflows is higher than the present value of the cost of the asset or project, the project shall be accepted, as it would generate profit.

$\begin{array}{c}NPV=-\widehat{C{F}_0}+\frac{{\widehat{CF}}_1}{{\left(1+r\right)}^1}+\frac{{\widehat{CF}}_2}{{\left(1+r\right)}^2}+\mathrm{.......}+\frac{\widehat{C{F}_n}}{{\left(1+r\right)}^n}\\ ={\displaystyle \sum _{t=0}^n\frac{\widehat{C{F}_t}}{{\left(1+r\right)}^t}\mathrm{\hspace{1em}\hspace{1em}\hspace{1em}\hspace{1em}\hspace{1em}\hspace{1em}\hspace{1em}\hspace{1em}\hspace{1em} }}\end{array}$

A project will cost $42,000 and generate $11,000 for next 5 years. Required rate of return is 9%.