CAPITAL BUDGETING CRITERIA: MUTUALLY EXCLUSIVE PROJECTS Project S costs $18,000
ID: 2826621 • Letter: C
Question
CAPITAL BUDGETING CRITERIA: MUTUALLY EXCLUSIVE PROJECTS
Project S costs $18,000 and its expected cash flows would be $4,000 per year for 5 years. Mutually exclusive Project L costs $26,000 and its expected cash flows would be $11,100 per year for 5 years. If both projects have a WACC of 13%, which project would you recommend? Select the correct answer.
a. Neither Project S nor L, since each project's NPV < 0.
b. Project S, since the NPVS > NPVL.
c. Project L, since the NPVL > NPVS.
d. Both Projects S and L, since both projects have NPV's > 0.
e. Both Projects S and L, since both projects have IRR's > 0.
IRR AND NPV
A company is analyzing two mutually exclusive projects, S and L, with the following cash flows:
The company's WACC is 10.5%. What is the IRR of the better project? (Hint: The better project may or may not be the one with the higher IRR.) Round your answer to two decimal places.
0 1 2 3 4Explanation / Answer
a.
S:
Present value of annuity=Annuity[1-(1+interest rate)^-time period]/rate
=$4000[1-(1.13)^-5]/0.13
=$4000*3.517231262
=$14068.93
NPV=Present value of inflows-Present value of outflows
=$14068.93-$18000
=($3931.07)(Approx)(Negative).
L:
Present value of annuity=$11100[1-(1.13)^-5]/0.13
=$11100*3.517231262
=$39041.27
NPV =$39041.27-$26000
=$13041.27(Approx)
Hence Project L must be chosen having higher NPV.(option C).
2.
Present value of inflows=cash inflow*Present value of discounting factor(rate%,time period)
S:
Present value of inflows=896.96/1.105+240/1.105^2+5/1.105^3+5/1.105^4
=$1015.34
NPV=Present value of inflows-Present value of outflows
=$1015.34-$1000
=$15.34(Approx).
L:
Present value of inflows=5/1.105+260/1.105^2+400/1.105^3+764.90/1.105^4
=$1026.97
NPV=Present value of inflows-Present value of outflows
=$1026.97-$1000
=$26.97(Approx).
Hence the better project is L having higher NPV.
Let irr be x%
At irr,present value of inflows=present value of outflows.
1000=5/1.0x+260/1.0x^2+400/1.0x^3+764.90/1.0x^4
Hence x=irr=11.40%(Approx).
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