Question

The following two projects of equal risk are mutually exclusive alternatives for expanding the firm’s capacity. The firm’s cost of capital is 15%. The cash flows for each project are given in the following table.

	PROJECT A	PROJECT B
Initial investment	210,000	20,000
Year	Net cash inflows	Net cash inflows
1	15,000	12,000
2	30,000	10,500
3	32,000	9,500
4	425,000	8,200

Answer 1

To determine which project should be selected we can compute the NPV.

Year	A's cash flow	B's cash flow	1+r	PVIF = 1/(1+r)^n	PV of A = cash flow of A *PVIF	PV of B = cash flow of B *PVIF
0	-        210,000.00	-           20,000.00	1.15	1.0000	-        210,000.00	-          20,000.00
1	15,000.00	12,000.00		0.8696	13,043.48	10,434.78
2	30,000.00	10,500.00		0.7561	22,684.31	7,939.51
3	32,000.00	9,500.00		0.6575	21,040.52	6,246.40
4	425,000.00	8,200.00		0.5718	242,995.13	4,688.38
				NPV	89,763.44	9,309.07

Thus A has a higher NPV and hence A will be selected.