Question

Project S requires an initial outlay at t = 0 of $12,000, and its expected cash flows would be $6,500 per year for 5 years. Mutually exclusive Project L requires an initial outlay at t = 0 of $45,000, and its expected cash flows would be $13,150 per year for 5 years. If both projects have a WACC of 16%, which project would you recommend?

Select the correct answer.

a. Project L, since the NPVL > NPVS.

b. Neither Project S nor L, since each project's NPV < 0.

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

d. Both Projects S and L, since both projects have IRR's > 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:

= - $ 12,000 + $ 6,500 / 1.16¹ + $ 6,500 / 1.16² + $ 6,500 / 1.16³ + $ 6,500 / 1.16⁴ + $ 6,500 / 1.16⁵

= $ 9,282.91 Approximately

The NPV of Project L is computed as follows:

= - $ 45,000 + $ 13,150 / 1.16¹ + $ 13,150 / 1.16² + $ 13,150 / 1.16³ + $ 13,150 / 1.16⁴ + $ 13,150 / 1.16⁵

= - $ 1,943.04 Approximately

Since these two projects are mutually exclusive, hence we need to select the one which has the higher NPV. Since the NPV of project S is greater than the NPV of project L, hence Project S shall be accepted.

So, the correct answer is option e.

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