Problem 11-11 Capital budgeting criteria: mutually exclusive projects Project S

Question

Problem 11-11

Capital budgeting criteria: mutually exclusive projects

Project S costs $18,000 and its expected cash flows would be $6,500 per year for 5 years. Mutually exclusive Project L costs $38,500 and its expected cash flows would be $10,500 per year for 5 years. If both projects have a WACC of 14%, which project would you recommend?

Select the correct answer.

I. Both Projects S and L, since both projects have IRR's > 0. II. Project L, since the NPVL > NPVS. III. Both Projects S and L, since both projects have NPV's > 0. IV. Project S, since the NPVS > NPVL. V. Neither S or L, since each project's NPV < 0.

Explanation / Answer

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

S:

Present value of inflows=6500/1.14+6500/1.14^2+........+6500/1.14^5

=$22315.03

NPV=Present value of inflows-Present value of outflows

=22315.03-18000

=$4315.03

L:

Present value of inflows=10500/1.14+10500/1.14^2+.............+10500/1.14^5

=$36047.35

NPV =$36047.35-$38500

=($2452.65)

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

Hence the correct option is 4.

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