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	$45	$45	$45	$160	$160
Project 2	-$450	$300	$300	$60	$60	$60

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

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

e. Project 2, since the NPV2 > NPV1.

Answer 1

Answer :- e. Project 2, since the NPV₂ > NPV₁.

In case of mutually exclusive projects one project can be selected for Investment and excludes all other projects from consideration.

We will calculate the NPV of both the projects and the project with highest NPV will be selected .Given WACC 10%.

NPV of project A = PV of cash inflows discounted at 10% - Initial Investment

= 45/(1.10) + 45/(1.10)^2 + 45/(1.10)^3 + 160/(1.10)^4 + 160/(1.10)^5 - $500

= -$179.46

NPV of project B = 300/(1.10) + 300/(1.10)^2 + 60(1.10)^3 + 60(1.10)^4 + 60(1.10)^5 -$450

= $193.98

Hence project B will be selected because of higher NPV.