Question

CAPITAL BUDGETING CRITERIA: MUTUALLY EXCLUSIVE PROJECTS

Project S costs $15,000 and its expected cash flows would be $6,500 per year for 5 years. Mutually exclusive Project L costs $45,000 and its expected cash flows would be $9,900 per year for 5 years. If both projects have a WACC of 16%, which project would you recommend?

Select the correct answer.

a. Project S, since the NPVS > NPVL.

b. Both Projects S and L, since both projects have NPV's > 0.

c. Project L, since the NPVL > NPVS.

d. Neither Project S nor L, since each project's NPV < 0.

e. Both Projects S and L, since both projects have IRR's > 0.

Answer 1

Present value of annuity=Annuity[1-(1+interest rate)^-time period]/rate

S:

Present value of annuity=$6500[1-(1.16)^-5]/0.16

=$6500*3.274293654

=$21282.91

NPV=Present value of inflows-Present value of outflows

=$21282.91-$15000

=$6282.91

L:

Present value of annuity=$9900[1-(1.16)^-5]/0.16

=$9900*3.274293654

=$32415.51

NPV=Present value of inflows-Present value of outflows

  =$32415.51-$45000

=(12584.49)(Negative).

Hence S must be chosen having posiitve and higher NPV.

Hence the correct option is A.