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	-$400	$65	$65	$65	$210	$210
Project 2	-$400	$300	$300	$55	$55	$55

Which project would you recommend?

Select the correct answer.

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

II. Project 2, since the NPV2 > NPV1.

III. Neither A or B, since each project's NPV < 0.

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

V. Project 1, since the NPV1 > NPV2.

Answer 1

1:

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

=65/1.1+65/1.1^2+65/1.1^3+210/1.1^4+210/1.1^5

=$435.47

NPV=Present value of inflows-Present value of outflows

=$435.47-$400

=$35.47(Approx).

2:

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

=300/1.1+300/1.1^2+55/1.1^3+55/1.1^4+55/1.1^5

=$633.70

NPV=Present value of inflows-Present value of outflows

=$633.70-$400

=$233.70(Approx).

Hence project 2 must be selected having higher NPV.(Option 2).