Question

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 $29,500 and its expected cash flows would be $9,200 per year for 5 years. If both projects have a WACC of 12%, which project would you recommend?

Select the correct answer.

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

b. Neither Project S nor L, since each project's NPV < 0.

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

d. Project L, since the NPVL > NPVS.

e. Project S, since the NPVS > NPVL.

Answer 1

Project S

Net present value is solved using a financial calculator. The steps to solve on the financial calculator:

• Press the CF button.
• CF0= -$18,000. It is entered with a negative sign since it is a cash outflow.
• Cash flow for all the years should be entered.
• Press Enter and down arrow after inputting each cash flow.
• After entering the last cash flow, press the NPV button and enter the weighted average cost of capital of 12%.
• Press the down arrow and CPT buttons to get the net present value.

Net Present value of cash flows at 12% the weighted average cost of capital is $5,431.05.

Project L

Net present value is solved using a financial calculator. The steps to solve on the financial calculator:

• Press the CF button.
• CF0= -$29,500. It is entered with a negative sign since it is a cash outflow.
• Cash flow for all the years should be entered.
• Press Enter and down arrow after inputting each cash flow.
• After entering the last cash flow, press the NPV button and enter the weighted average cost of capital of 12%.
• Press the down arrow and CPT buttons to get the net present value.

Net Present value of cash flows at 12% the weighted average cost of capital is $3,663.94.

I would recommend Project S since it has a higher net present value.

Hence, the answer is option e.

In case of any query, kindly comment on the solution.