Question

Project S costs $11,000 and its expected cash flows would be $4,500 per year for 5 years. Mutually exclusive Project L costs $27,000 and its expected cash flows would be $7,500 per year for 5 years. If both projects have a WACC of 13%, which project would you recommend?

Select the correct answer.

I. Neither S or L, since each project's NPV < 0.

II. Project L, since the NPVL > NPVS.

III. Both Projects S and L, since both projects have NPV's > 0.

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

V. Project S, since the NPVS > NPVL.

Answer 1

When projects are mutually exclusive, we always choose the project with the higher NPV.

Project S:

NPV = Present value of cash inflows - present value of cash outflows

NPV = Annuity * [1 - 1 / (1 + r)ⁿ] / r - Initial investment

NPV = 4,500 * [1 - 1 / (1 + 0.13)⁵] / 0.13 - 11,000

NPV = 4,500 * [1 - 0.54276] / 0.13 - 11,000

NPV = 4,500 * 3.517231 - 11,000

NPV = $4,827.54

Project L:

NPV = Present value of cash inflows - present value of cash outflows

NPV = Annuity * [1 - 1 / (1 + r)ⁿ] / r - Initial investment

NPV = 7,500 * [1 - 1 / (1 + 0.13)⁵] / 0.13 - 27,000

NPV = 7,500 * [1 - 0.54276] / 0.13 - 27,000

NPV = 7,500 * 3.517231 - 27,000

NPV = -620.77

V. Project S, since the NPV_S > NPV_L