Question

CAPITAL BUDGETING CRITERIA: MUTUALLY EXCLUSIVE PROJECTS

A firm with a WACC of 10% is considering the following mutually exclusive projects:

0

1

2

3

4

5

Project 1	-$400	$45	$45	$45	$230	$230
Project 2	-$650	$200	$200	$40	$40	$40

Which project would you recommend?

Select the correct answer.

a. Neither Project 1 nor 2, since each project's NPV < 0.

b. Project 2, since the NPV2 > NPV1.

c. Both Projects 1 and 2, since both projects have IRR's > 0.

d. Project 1, since the NPV1 > NPV2.

e. Both Projects 1 and 2, since both projects have NPV's > 0.

Answer 1

Project 1:

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

=45/1.1+45/1.1^2+45/1.1^3+230/1.1^4+230/1.1^5

=411.81

NPV=Present value of inflows-Present value of outflows

=411.81-$400

=$11.81(Approx).

Project 2:

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

=200/1.1+200/1.1^2+40/1.1^3+40/1.1^4+40/1.1^5

=429.32

NPV=Present value of inflows-Present value of outflows

=429.32-$650

=$(220.68)(Approx).(Negative).

Hence Project 1 must be selected having higher and positive NPV.

Hence the correct option is:

d. Project 1, since the NPV₁ > NPV_2.