Consider two projects: Project A currently costs $13 million, which is to be pai

Question

Consider two projects: Project A currently costs $13 million, which is to be paid this year. The returns are $10 million after in one year and $9 million in two years. Project B currently costs $16 million, again to be paid this year. The returns are $13 million after in one year and $11 million in two years. At an interest rate of 10%, the net present value of Project A is roughly (3.17 million, 3.53 million, 4.27 million, 6.00 million or 16.53 million), while the net present value of Project B is roughly (4.88 million, 4.91 million, 5.82 million, 8.00 million, 20.91 million) Suppose investing in one project eliminates the opportunity to invest in the other. If the interest rate is 10%, Project (A or B) is preferable.

Explanation / Answer

NPV is the sum of all cash outflows & inflows discounted at 10%.

NPV, project A ($ mill) = - 13 + (10 / 1.1) + [9 / (1.1)2] = - 13 + 9.09 + 7.44 = 3.53

NPV, project B ($ mill) = - 16 + (13 / 1.1) + [11 / (1.1)2] = - 16 + 11.82 + 0.09 = 4.91

Since the projects are mutually exclusive, the project with higher NPV should be chosen, that is, project B is preferred.

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