Santa Clara Corporation is considering investments G and H. Initial costs and ye

Question

Santa Clara Corporation is considering investments G and H. Initial costs and year-end cash flows follow. The limiting resource that caused the two investments to be mutually exclusive can be reused. The required return is 6.5 percent.

Year 0 1 2 3 4 5   

G -150,000 45,000 45,000 45,000 80,000

H -95,000 35,000 25,000 55,000 45,000 60,000

Net present value for project G_____________ Equivalent annuity for project G_________

Net present value for project H__                      __ Equivalent annuity for project H_________

Which investment should be chosen? _______________

Explanation / Answer

NPV for project G = -150,000 + 45,000 / (1+6.5%)^1 + 45,000 / (1+6.5%)^2 + 45,000 / (1+6.5%)^3 + 80,000 / (1+6.5%)^4 = 31,367.25

Let Equivalent annuity be X

So NPV = X * (1-1/(1+6.5%)^4) / 6.5%

31,367.25 = X * (1-1/(1+6.5%)^4) / 6.5%

i.e. 31,367.25 = X * 3.4258

Solving, we get X = equivalent annuity = 9,156.18

NPV for project H = -95,000 + 35,000 / (1+6.5%)^1 + 25,000 / (1+6.5%)^2 + 55,000 / (1+6.5%)^3 + 45,000 / (1+6.5%)^4 + 60,000 / (1+6.5%)^5 = 84,209.42

Let Equivalent annuity be Y

So NPV = Y * (1-1/(1+6.5%)^5) / 6.5%

84,209.42 = Y * (1-1/(1+6.5%)^4) / 6.5%

i.e. 84,209.42 = Y * 4.1557

Solving, we get X = equivalent annuity = 20,263.70

So final answer is:

NPV for Project G is $ 31,367.25. Equivalent annuity for project G = $ 9,156.18

NPV for Project H is $ 84,209.42. Equivalent annuity for project H = $ 20,263.70

As the Equivalent annuity as well as NPV for Project H is higher, we should select Project H.

Hope this helped ! Let me know in case of any queries.

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