Q15SE - Horngren'S Financial And Managerial Accounting

Question

Hicks Company is considering an investment opportunity with the following expected net cash inflows: Year 1, \(235,000; Year 2, \)195,000; Year 3, \(125,000. The company uses a discount rate of 6%, and the initial investment is \)365,000. Calculate the NPV of the investment. Should the company invest in the project? Why or why not?

Step-by-Step Solution

Answer

The company must invest in the project as net present value is positive.

Step 1: Definition of Net Present Value

A metric that determines the present value of all the stream of cash inflows that will be received in the future period of time is known as net present value. It is also used in capital budgeting.

Step 2: Calculation of net present value

Time	Particular	Net cash inflow	PV factor	Present value
Year 1	PV	$235,000	0.943	$221,605
Year 2	PV	$195,000	0.890	173,550
Year 3	PV	$125,000	0.840	105,000
Present value of cash inflows				$500,155
Less: Initial investment				($365,000)
Net present value				$135,155

Note: net present value of the project is positive reflecting that the business entity must invest in the project.