Question

Morgan Corporation is trying to decide which one of two projects it should accept. Both projects have the same start-up cost. Project 1 will produce annual cash flows of $52,000 a year for six years. Project 2 will produce cash flows of $48,000 a year for eight years. The company requires a 15 percent rate of return. Which project should the company select and why?

Answer 1

Since both the projects are having same start up costs, the start up costs shall not be used for decision making. The project with higher Present value of annual cash inflows shall be accepted

Present value of annuity of uniform amount = Amount * {1-(1+r)^-n}/r

Present value of annual cash flow of Project 1 = $52,000*(1-1.15^-6)/0.15 = $196,793.10

Present value of annual cash flow of Project 1 = $48,000*(1-1.15^-8)/0.15 = $215,391.93

Company should select project 2 because it is having higher present value of annual cash flows.