Question

You are considering the following two mutually exclusive projects. The required return on each project is 16 percent. Which project should you accept and what is the best reason for that decision?

Year

Project A

Project B

0

-$10,000

-$20,000

1

$8,000

$16,000

2

$4,000

$9,000

3

$3,000

$5,000

4

$9,000

$7,000

A. Project A; because it pays back faster
B. Project A; because it has the higher internal rate of return
C. Project B; because it has the higher internal rate of return
D. Project A; because it has the higher net present value
E. Project B; because it has the higher net present value

Answer 1

The NPV of Project A 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 is computed as follows:

= - $ 10,000 + $ 8,000 / 1.16 + $ 4,000 / 1.16² + $ 3,000 / 1.16³ + $ 9,000 / 1.16⁴

= $ 6,761.80

The NPV of Project B 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 is computed as follows:

= - $ 20,000 + $ 16,000 / 1.16 + $ 9,000 / 1.16² + $ 5,000 / 1.16³ + $ 7,000 / 1.16⁴

= $ 7,550.90

So, the correct answer will be option E i.e. Project B; because it has the higher net present value

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