Question

As the director of capital budgeting for Denver Corporation, you are evaluating two mutually exclusive projects with the following net cash flows.

Project X has cash flows of -100,000 in year 0, 50,000 in year 1, 40,000 in year 2, 30,000 in year 3 and 10,000 in year 4.

Project Z has cash flows of -100,000 in year 0, 10,000 in year 1, 30,000 in year 2, 40,000 in year 3 and 60,000 in year 4.

If Denver's cost of capital is 15 percent, which project would you choose?

Answer 1

The Net Present Value of Project X is computed as shown below:

= Initial cash outflow + year 1 cash flow / (1 + cost of capital )¹ + year 2 cash flow / (1 + cost of capital )² + year 3 cash flow / (1 + cost of capital )³ + year 4 cash flow / (1 + cost of capital )⁴

= - 100,000 + 50,000 / 1.15 + 40,000 / 1.15² + 30,000 / 1.15³ + 10,000 / 1.15⁴

= - 832.97 Approximately

The Net Present Value of Project Z is computed as shown below:

= Initial cash outflow + year 1 cash flow / (1 + cost of capital )¹ + year 2 cash flow / (1 + cost of capital )² + year 3 cash flow / (1 + cost of capital )³ + year 4 cash flow / (1 + cost of capital )⁴

= - 100,000 + 10,000 / 1.15 + 30,000 / 1.15² + 40,000 / 1.15³ + 60,000 / 1.15⁴

= - 8,014.19 Approximately

Since the NPV of both the projects are negative, hence we shall not choose any project.

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