Question

CAPITAL BUDGETING CRITERIA: MUTUALLY EXCLUSIVE PROJECTS

A firm with a WACC of 10% is considering the following mutually exclusive projects:

0

1

2

3

4

5

Project 1	-$250	$75	$75	$75	$170	$170
Project 2	-$700	$200	$200	$50	$50	$50

Which project would you recommend?

Select the correct answer.

a. Neither Project 1 nor 2, since each project's NPV < 0.

b. Both Projects 1 and 2, since both projects have NPV's > 0.

c. Project 1, since the NPV1 > NPV2.

d. Project 2, since the NPV2 > NPV1.

e. Both Projects 1 and 2, since both projects have IRR's > 0.

Answer 1

Present value of inflows=cash inflow*Present value of discounting factor(rate%,time period)

Project 1:

Present value of inflows=75/1.1+75/1.1^2+75/1.1^3+170/1.1^4+170/1.1^5

=$408.18

NPV=Present value of inflows-Present value of outflows

=408.18-250

=$158.18

Project 2:

Present value of inflows=200/1.1+200/1.1^2+50/1.1^3+50/1.1^4+50/1.1^5

=$449.87

NPV =$449.87-$700

=($250.13)(Approx)(Negative).

Hence Project 1 must be selected having higher and positive NPV.(C).