Question

A firm has the following investment alternatives.

A firm has the following investment alternatives.

Year    Project A        Project B

Cash Flow       Cash Flow

              0        -$100,000        -$100,000

  1            50,000              10,000

  2            40,000              30,000

  3            30,000              40,000

  4            10,000              60,000

The firm's cost of capital is 7%. Project A and project B are mutually exclusive. Which investment(s) should the firm make?

		Project A because it has the higher IRR
		Project A because it has the higher NPV
		Neither because both have IRRs less than the cost of capital
		Project B because it has the higher NPV
		Project B because it has the higher IRR

Answer 1

A:

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

=50,000/1.07+40,000/1.07^2+30,000/1.07^3+10,000/1.07^4

=113784.41

NPV=Present value of inflows-Present value of outflows

=113784.41-100,000

=$13784.41(Approx)

B:

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

=10,000/1.07+30,000/1.07^2+40,000/1.07^3+60,000/1.07^4

=113974.58

NPV=Present value of inflows-Present value of outflows

=113974.58-100,000

=$13974.58(Approx)

When projects are mutually exclusive;project having higher NPV must be selected which would lead to higher value addition to the firm.

Since projects are mutually exclusive;project B must be selected having higher NPV.

Hence the correct option is:

Project B because it has the higher NPV