Question

Project S costs $14,000 and its expected cash flows would be $6,500 per year for 5 years. Mutually exclusive Project L costs $37,500 and its expected cash flows would be $14,700 per year for 5 years. If both projects have a WACC of 13%, which project would you recommend?

a. Project L, since the NPVL > NPVS.

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

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

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

e. Project S, since the NPVS > NPVL.

Answer 1

The NPV is computed as shown below:

= Initial investment + Present value of future cash flows

Present value is computed as follows:

= Future value / (1 + r)ⁿ

The NPV of Project S is computed as follows:

= - $ 14,000 + $ 6,500 / 1.13¹ + $ 6,500 / 1.13² + $ 6,500 / 1.13³ + $ 6,500 / 1.13⁴ + $ 6,500 / 1.13⁵

= $ 8,862 Approximately

The NPV of Project L is computed as follows:

= - $ 37,500 + $ 14,700 / 1.13¹ + $ 14,700 / 1.13² + $ 14,700 / 1.13³ + $ 14,700 / 1.13⁴ + $ 14,700 / 1.13⁵

= $ 14,203 Approximately

Since these two projects are mutually exclusive, hence we need to select the one which has the higher NPV. Since the NPV of project L is greater than the NPV of project S, hence Project L shall be accepted.

So, the correct answer is option a.