[lz221476]

The net present value (NPV) of a project has been calculated to be $215,000. Which one of the following

changes in assumptions would decrease the NPV?

a. Decrease the estimated effective income tax rate.

b. Extend the project life and associated cash inflows.

c. Increase the estimated salvage value.

d. Increase the discount rate.

Answer is d. I am super confused with the explanation. I thought NPV= initial investment cost- total discounted cash flow, so if initial investment cost is unchanged, the NPV should decrease when total discounted cash flow increase.

Here are the explanation:

Choice “d” is correct. An increase in the discount rate will decrease the present value of future cash inflows

and, therefore, decrease the net present value of the project.

Choice “a” is incorrect. A decrease in the estimated effective income tax rate will reduce the depreciation tax

shield and therefore increase the cash inflow. A larger cash inflow in the future will increase the present value

of the cash inflows and therefore increase the net present value of the project.

Choice “b” is incorrect. Increasing the project life and associated cash inflows will increase the present value

of the cash inflows and therefore increase the net present value.

Choice “c” is incorrect. An increase in the estimated salvage value will decrease the present value of the

cash outflow and therefore increase the net present value.

[tphil]

Your NPV equation is backwards. NPV=total discounted cash flows-initial investment. I think the explanation and answer choice should make sense now.

When you think about NPV, obviously you want it to be positive, which means that your incoming cash flows have to be greater than your outflows. This is why the equation should be set up as I have it. When your total discounted cash flows increase, that's a good thing, and NPV will thus also increase (holding initial investment unchanged) and NPV will decrease when total discounted cash flows decrease, so choice d the correct answer.

[lz221476]

still don't understand about they two:

Choice “a” is incorrect. A decrease in the estimated effective income tax rate will reduce the depreciation tax

shield and therefore increase the cash inflow. ( I think a reduced effective income tax rate–>a decreased tax shield–>less cash flow?)

Choice “c” is incorrect. An increase in the estimated salvage value will decrease the present value of the

cash outflow and therefore increase the net present value.( Increased salvage value –>more cash flow?)

[Anonymous]

@lz221476 – For solution A being incorrect: When you decrease the effective tax rate, that means you are paying less money in taxes and that means you have higher income. Higher income = Higher cash flow = Higher NPV.

For solution C being incorrect: I am not 100% sure on my explanation of this, but think of it this way. When the estimated salvage value increases, that means you can sell it for more later. Again, being able to get more money later means higher cash flows.

Hope this helps!

[lz221476]

Thanks guys, both of your answers helps!

[Author]

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