Question

(Capital Budgeting Criteria: Mutually Exclusive Projects)

Project S costs $17,000 and its expected cash flows would be $4,500 per year for 5 years. Mutually exclusive Project L costs $28,500 and its expected cash flows would be $11,250 per year for 5 years. If both projects have a WACC of 15%, which project would you recommend?

Select the correct answer.

a. Project L, since the NPVL > NPVS.

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

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

d. Neither Project S nor L, since each project's NPV < 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:

= - $ 17,000 + $ 4,500 / 1.15¹ + $ 4,500 / 1.15² + $ 4,500 / 1.15³ + $ 4,500 / 1.15⁴ + $ 4,500 / 1.15⁵

= - $ 1,915.30 Approximately

The NPV of Project L is computed as follows:

= - $ 28,500 + $ 11,250 / 1.15¹ + $ 11,250 / 1.15² + $ 11,250 / 1.15³ + $ 11,250 / 1.15⁴ + $ 11,250 / 1.15⁵

= $ 9,211.74 Approximately

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

So, the correct answer is option a.

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