Question

Capital budgeting criteria: mutually exclusive projects

Project S costs $15,000 and its expected cash flows would be $5,500 per year for 5 years. Mutually exclusive Project L costs $40,500 and its expected cash flows would be $10,800 per year for 5 years. If both projects have a WACC of 15%, which project would you recommend?

Select the correct answer.

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

II. Project L, since the NPVL > NPVS.

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

IV. Project S, since the NPVS > NPVL.

V. Neither S or L, since each project's NPV < 0.

Answer 1

S:

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

=5500/1.15+5500/1.15^2+5500/1.15^3+5500/1.15^4+5500/1.15^5

=18436.85

NPV=Present value of inflows-Present value of outflows

=18436.85-15000

=$3436.85(Approx)

L:

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

=10800/1.15+10800/1.15^2+10800/1.15^3+10800/1.15^4+10800/1.15^5

=36203.28

NPV=Present value of inflows-Present value of outflows

=36203.28-40500

=-4296.72(Approx)(Negative)

Hence project S must be selected having higher and positive NPV.

Hence the correct option is:

Project S, since the NPV_S > NPV_L