Question

Consider the following two projects A and B. Assume that the appropriate discount rate for each project is 20%.

Year	CF for Project A	CF for Project B
0 1 2 3	- $100 70 80 90	- $1,700 900 900 900

If projects A and B are mutually exclusive projects, which project(s) should you accept based on your best capital budgeting criteria? Please explain your rationale.

Answer 1

In mutually exclusive projects, the acceptance of one project leads to the rejection of another project. Hence, we can choose only 1 project.

Out of NPV and IRR method, NPV is the best method for capital budgeting criteria as it gives more importance to the time value of money.

NPV is given by:

NPV = L Rt/(1 + i) ,t varies from 1 ton where Rt = Cash flow netted (Inflow - Outflow) during the period "t" i = Discount rate t = number of periods

For Project A

NPV = [70 / (1 + 20%)^¹] + [80 / (1 + 20%)^²] + [90 / (1 + 20%)^³] - Initial Investment

NPV = 58.33 + 55.56 + 52.08 - 100

NPV = $ 65.97

For Project B

NPV = [900 / (1 + 20%)^¹] + [900 / (1 + 20%)^²] + [900 / (1 + 20%)^³] - Initial Investment

NPV = 750 + 625 + 520.83 - 1700

NPV = $ 195.83

So both NPV are positive.

Since, NPV of Project B > NPV of Project A, we should choose Project B