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 -$250 $50 $50 $50 $175 $175 Project 2 -$700 $350 $350 $80 $80 $80 Which project would you recommend? Select the correct answer.

a. Project 2, since the NPV2 > NPV1.

b. Project 1, since the NPV1 > NPV2.

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

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

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

Answer 1

When projects are mutually exclusive, we should always choose the project which has the higher NPV

Project 1:

NPV for project 1 = Present value of cash inflows - present value of cash outflows

NPV for project 1 = -250 + 50 / (1 + 0.1)¹ + 50 / (1 + 0.1)² + 50 / (1 + 0.1)³ + 175 / (1 + 0.1)⁴ + 175 / (1 + 0.1)⁵

NPV for project 1 = $102.53

Project 2:

NPV for project 2 = Present value of cash inflows - present value of cash outflows

NPV for project 2 = -700 + 350 / (1 + 0.1)¹ + 350 / (1 + 0.1)² + 350 / (1 + 0.1)³ + 80 / (1 + 0.1)⁴ + 80 / (1 + 0.1)⁵

NPV for project 2 = $71.85

b. Project 1, since the NPV1 > NPV2.