Question

# (Capital Budgeting Criteria: Mutually Exclusive Projects) A firm with a WACC of 10% is considering the...

(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?

 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.

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

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