Question

Project S requires an initial outlay at t = 0 of $10,000, and its expected cash flows would be $4,500 per year for 5 years. Mutually exclusive Project L requires an initial outlay at t = 0 of $28,500, and its expected cash flows would be $13,200 per year for 5 years. If both projects have a WACC of 12%, 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 NPV's > 0.

c. Project S, since the NPVS > NPVL.

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

e. Project L, since the NPVL > NPVS.

Answer 1

S:

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

=4500/1.12+4500/1.12^2+4500/1.12^3+4500/1.12^4+4500/1.12^5

=16221.49

NPV=Present value of inflows-Present value of outflows

=16221.49-10,000

=$6221.49(Approx)

L:

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

=13200/1.12+13200/1.12^2+13200/1.12^3+13200/1.12^4+13200/1.12^5

=47583.05

NPV=Present value of inflows-Present value of outflows

=47583.05-28500

=$19083.05(Approx)

Hence since projects are mutually exclusive;project L must be selected having higher NPV.

Hence the correct option is:

Project L, since the NPV_L > NPV_S.