Question

Project S costs $16,000 and its expected cash flows would be $4,000 per year for 5 years. Mutually exclusive Project L costs $29,500 and its expected cash flows would be $9,300 per year for 5 years. If both projects have a WACC of 14%, which project would you recommend?

Select the correct answer.

a. Neither Project S nor L, since each project's NPV < 0.

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

c. Project S, since the NPVS > NPVL.

d. Project L, since the NPVL > NPVS.

Answer 1

S:

Present value of annuity=Annuity[1-(1+interest rate)^-time period]/rate

=$4000[1-(1.14)^-5]/0.14

=$4000*3.433080969

=$13732.32

NPV=Present value of inflows-Present value of outflows

=$13732.32-$16000

=($2267.68)(Approx)(Negative).

L:

Present value of annuity=Annuity[1-(1+interest rate)^-time period]/rate

=$9300[1-(1.14)^-5]/0.14

=$9300*3.433080969

=$31927.65

NPV=Present value of inflows-Present value of outflows

=$31927.65-$29500

=$2427.65(Approx).

Hence L must be selected only having a positive and higher NPV.(Option D).