Question

Dudley firm with a WACC of 10% is considering the following mutually

exclusive projects: 0 1 2 3 4 5

Project 1 -$400 $55 $55 $55 $175 $175

Project 2 -$450 $350 $350 $105 $105 $105

Which project would you recommend? Select the correct answer.

a. Project 1, since the NPV1 > NPV2.

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

c. Project 2, since the NPV2 > NPV1.

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

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

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

So, the NPV of project 1 is computed as follows:

= - $ 400 +  $55 / 1.10¹ + $55 / 1.10² +  $55 / 1.10³ + $175 / 1.10⁴ + $175 / 1.10⁵

= - $ 35.03 Approximately

The NPV of project 2 is computed as follows:

= - $450 + $350 / 1.10 + $350 / 1.10² + $105 / 1.10³ +  $105 / 1.10⁴ + $105 /1.10⁵

= $ 373.24 Approximately

Since the NPV of project 2 is greater than the NPV of project 1, hence the correct answer is option c i.e. Project 2, since the NPV2 > NPV1.

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