NPV Formula (Annuity Method) capital budgeting sample problem with solution
Company X is evaluating a project requiring an initial investment of $200,000. It is expected to generate cash flows of $60,000 per year for 5 years. If the cost of capital is 10%, what is the Net Present Value (NPV), and should the project be accepted?
NPV Formula (Annuity Method) capital budgeting sample problem with solution
đź“ť Step-by-Step Calculation
1. Define the Variables
2. The NPV Formula (Annuity Method)
Since the cash flows are equal each year, we can use the Present Value of an Ordinary Annuity (PVOA) formula to find the present value of the inflows:
3. Execution & Calculation
First, calculate the Present Value Annuity Factor (PVAF):
Next, multiply the annuity factor by the annual cash inflow to find the Present Value (PV) of the inflows:
Finally, subtract the initial investment to find the NPV:
Executive Decision
Yes, Company X should accept the project. The project yields a positive Net Present Value (NPV) of $27,447.21, meaning it covers its initial costs, meets the required 10% cost of capital, and adds $27,447.21 in wealth to the firm’s shareholders. NPV Formula (Annuity Method) capital budgeting sample problem with solution
