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	-$500	$60	$60	$60	$235	$235
Project 2	-$600	$250	$250	$125	$125	$125

(this graph should have the 0 over the -500 and -600, the 1 over the 60 and 250, the 2 over the 60 and 250. the 3 over the 60 and 125, the 4 over the 235 and 125, and the 5 over the 235 and 125.) (I hope this makes sense, it was hard to get the graph to upload properly. )

Which project would you recommend?

Select the correct answer.

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

b. Project 1, since the NPV1 > NPV2.

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

d. Project 2, since the NPV2 > NPV1.

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

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 1 is computed as follows:

= - $ 500 + $ 60 / 1.10¹ + $ 60 / 1.10² + $ 60 / 1.10³ + $ 235 / 1.10⁴ + $ 235 / 1.10⁵

= - $ 44.36 Approximately

The NPV of Project 2 is computed as follows:

= - $ 600 + $ 250 / 1.10¹ + $ 250 / 1.10² + $ 125 / 1.10³ + $ 125 / 1.10⁴ + $ 125 / 1.10⁵

= $ 90.79 Approximately

Since the NPV of project 2 is positive and greater than the NPV of project 1, hence project 2 shall be accepted.

So, the correct answer is option d.

Feel free to ask in case of any query relating to this question