Question

Project S requires an initial outlay at t = 0 of $18,000, and its expected cash flows would be $5,000 per year for 5 years. Mutually exclusive Project L requires an initial outlay at t = 0 of $43,000, and its expected cash flows would be $12,000 per year for 5 years. If both projects have a WACC of 12%, which project would you recommend? Select the correct answer.

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

b. Project L, since the NPVL > NPVS.

c. Project S, since the NPVS > NPVL.

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

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

Answer 1

S:

Present value of inflows=cash inflow*Present value of discounting factor(rate%,time period)

=5000/1.12+5000/1.12^2+5000/1.12^3+5000/1.12^4+5000/1.12^5

=18023.88

NPV=Present value of inflows-Present value of outflows

=18023.88-18000

=$23.88(Approx)

L:

Present value of inflows=cash inflow*Present value of discounting factor(rate%,time period)

=12000/1.12+12000/1.12^2+12000/1.12^3+12000/1.12^4+12000/1.12^5

=43257.31

NPV=Present value of inflows-Present value of outflows

=43257.31-43000

=$257.31(Approx)

Hence since projects are mutually exclusive;only project L must be selected having higher NPV.

Hence the correct option is:

b. Project L, since the NPVL > NPVS.