Question

Project S requires an initial outlay at t = 0 of $11,000, and its expected cash flows would be $4,000 per year for 5 years. Mutually exclusive Project L requires an initial outlay at t = 0 of $33,500, and its expected cash flows would be $13,100 per year for 5 years. If both projects have a WACC of 12%, which project would you recommend? Select the correct answer. a. Project S, since the NPVs > NPVĻ. b. Project L, since the NPVL > NPVş. c. Both Projects S and L, since both projects have NPV's > 0. d. Both Projects S and L, since both projects have IRR's > 0. e. Neither Project S nor L, since each project's NPV < 0.

Answer 1

Project S

Time	0	1	2	3	4	5
Cash flow of S	-11000	4000	4000	4000	4000	4000

WACC of S = 12%

NPV of the projects can be calculated using the formula:

NPV = C₀ + C₁/(1+r)¹ + C₂/(1+r)²+ C₃/(1+r)³+ C₄/(1+r)⁴+ C₅/(1+r)⁵

Cash flow of S is: C₀ = -11000, C₁ = 4000, C₂ = 4000, C₃ = 4000, C₄ = 4000, C₅ = 4000

NPV of S = -11000 + 4000/(1.12)¹ + 4000/(1.12)² + 4000/(1.12)³ + 4000/(1.12)⁴​​​​​​​ + 4000/(1.12)⁵​​​​​​​ = -11000+3571.428571+3188.77551+2847.120991+2542.072314+2269.707423 = 3419.104809

NPV of project S = 3419.104809

Project L

Time	0	1	2	3	4	5
Cash flow of L	-33500	13100	13100	13100	13100	13100

WACC of L = 12%

NPV of the projects can be calculated using the formula:

NPV = C₀ + C₁/(1+r)¹ + C₂/(1+r)²+ C₃/(1+r)³+ C₄/(1+r)⁴+ C₅/(1+r)⁵

Cash flow of L is: C₀ = -33500, C₁ = 13100, C₂ = 13100, C₃ = 13100, C₄ = 13100, C₅ = 13100

NPV of L = -33500 + 13100/(1.12)¹ + 13100/(1.12)² + 13100/(1.12)³​​​​​​​ + 13100/(1.12)⁴​​​​​​​ + 13100/(1.12)⁵​​​​​​​ = -33500+11696.428571+10443.239796+9324.321246+8325.286827+7433.29181 = 13722.5682507196

NPV of Project L = 13722.568

Since the projects are mutally exclusive, we can only select one project with highest NPV

NPV_L > NPV_S

So, we should select Project L as NPV_L > NPV_S

Option b is the correct option

Correct Answer -> Project L, since NPV_L > NPV_S