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	-$350	$40	$40	$40	$215	$215
Project 2	-$650	$200	$200	$70	$70	$70

Which project would you recommend?

Select the correct answer.

a. Project 1, since the NPV1 > NPV2.

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

c. Project 2, since the NPV2 > NPV1.

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

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

Answer 1

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

Project 1:

Present value of inflows=40/1.1+40/1.1^2+40/1.1^3+215/1.1^4+215/1.1^5

=$379.82

NPV=Present value of inflows-Present value of outflows

=(379.82-350)

=$29.82

Project 2:

Present value of inflows=200/1.1+200/1.1^2+70/1.1^3+70/1.1^4+70/1.1^5

=$490.97

NPV =$490.97-$650

=($159.03)(Negative)

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

Hence the correct option is A.