Virus Stopper Inc., a supplier of computer safeguard systems, uses a cost of cap

Question

Virus Stopper Inc., a supplier of computer safeguard systems, uses a cost of capital of 10 percent to evaluate average-risk projects, and it adds or subtracts 3 percentage points to evaluate projects of more or less risk. Currently, two mutually exclusive projects are under consideration. Both have a cost of $ 314 and will last 4 years. Project A, a riskier-than- average project, will produce annual end of year cash flows of $ 96. Project B, of less than average risk, will produce cash flows of $ 312 at the end of Years 3 and 4 only.

Explanation / Answer

The riskier-than-average project A will be evaluated using cost of capital of 13% (10% + 3%). Whereas the less than average risk project B will be evaluated using cost of capital of 7% (10% - 3%).

Project A

NPV = Annual Cash Inflows x Cumulative Present Value factor (13%, years 1 to 4) - Initial Cost

NPV = $96 x 2.97447132552 - $314 = (-)$28.45

Project B

NPV = Annual Cash Inflows x Cumulative Present Value factor (7%, years 3 to 4) - Initial Cost

NPV = $312 x 1.57919308891 - $314 = $178.71

Therefore, Project B is better as it has a positive NPV.

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