Question

Two mutually exclusive projects have an initial cost of $60,000 each. Project A produces cash inflows of $30,000, $37,000, and $20,000 for Years 1 through 3, respectively. Project B produces cash inflows of $80,000 in Year 2 only. The required rate of return is 10 percent for Project A and 11 percent for Project B. Which project(s) should be accepted and why?

Project A, because it has the higher required rate of return.

Project A, because it has the larger NPV.

Project B, because it has the largest cash inflow in Year 2.

Project B, because it has the higher required rate of return

Project B, because it has the larger NPV

Answer 1

The NPV is computed as shown below:

= Initial investment + Present value of future cash flows

Present value is computed as follows:

= Future value / (1 + r)ⁿ

So, the NPV of Project A is computed as follows:

= - $ 60,000 + $ 30,000 / 1.10 + $ 37,000 / 1.10² + $ 20,000 / 1.10³

= $ 12,877.54 Approximately

The NPV of Project B is computed as follows:

= - $ 60,000 + $ 80,000 / 1.11²

= $ 4,929.79 Approximately

Whenever we compare two mutually exclusive projects, we shall select the project which has a greater NPV. Hence the project that shall be selected will be Project A.

So, the correct answer is Project A, because it has the larger NPV.

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