Question

(Capital Budgeting Criteria: Mutually Exclusive Projects) Project S costs \$17,000 and its expected cash flows would...

(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?

 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.

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.

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

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