Capital budgeting criteria: mutually exclusive projects Project S costs $17,000

Question

Capital budgeting criteria: mutually exclusive projects

Project S costs $17,000 and its expected cash flows would be $5,500 per year for 5 years. Mutually exclusive Project L costs $30,000 and its expected cash flows would be $14,200 per year for 5 years. If both projects have a WACC of 16%, which project would you recommend?

Select the correct answer.

I. Project L, since the NPVL > NPVS. II. Both Projects S and L, since both projects have NPV's > 0. III. Project S, since the NPVS > NPVL. IV. Neither S or L, since each project's NPV < 0. V. Both Projects S and L, since both projects have IRR's > 0.

Explanation / Answer

NPV of project S

Cash outflow at time point 0 = -17,000. Cash inflows per year = 5,500 for next 5 years.

present value of inflows = amount/(1+wacc)^time

present value of all inflows of S:

NPV = outflow+PV of inflows = -17,000+18,008.62 = 1,008.62

IRR of S will be calculated using a trial and error approach. IRR is the rate which will make the NPV as nil.

Using the solver function in excel, IRR is:

IRR = 18.52%

Project L's NPV calculation:

NPV = 46,494.97 - 30,000 = 16,494.97

IRR calculation using solver in excel:

IRR of project L = 37.81%.

As the projects are mutually exclusive, one will be accepted and one will be rejected. For both projects NPV>0 and IRR is greater than cost of capital.

For project L, both the NPV as well as the IRR is greater than NPV and IRR of project S.

So, the answer is option I - Project L, since the NPVL > NPVS

Year Amount 1+wacc PV 1 5,500.00 1.16 4,741.38 2 5,500.00 4,087.40 3 5,500.00 3,523.62 4 5,500.00 3,037.60 5 5,500.00 2,618.62 Total 18,008.62

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