Question

Capital budgeting criteria: mutually exclusive projects. Project S costs $17,000 and its expected cash flow would be $5,000 per year 5 years. Mutually exclusive Project L costs $30,000 and its expected cash flow would be $8,750 per year for 5 years. If both projects have a WACC of 12%, which project would you recommend? Explain.

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Answer 1

Project S:

Cost = $17,000
Expected Cash Flows = $5,000
Life of Project = 5 years
WACC = 12%

NPV = -$17,000 + $5,000/1.12 + $5,000/1.12^2 + $5,000/1.12^3 + $5,000/1.12^4 + $5,000/1.12^5
NPV = -$17,000 + $5,000 * (1 - (1/1.12)^5) / 0.12
NPV = -$17,000 + $5,000 * 3.60478
NPV = $1,023.90

Project L:

Cost = $30,000
Expected Cash Flows = $8,750
Life of Project = 5 years
WACC = 12%

NPV = -$30,000 + $8,750/1.12 + $8,750/1.12^2 + $8,750/1.12^3 + $8,750/1.12^4 + $8,750/1.12^5
NPV = -$30,000 + $8,750 * (1 - (1/1.12)^5) / 0.12
NPV = -$30,000 + $8,750 * 3.60478
NPV = $1,541.83

NPV of Project L is higher than that of Project S. So, we should choose Project L.