Question

A company is considering three capital budgeting projects. Data relative to each is given below. Each project has a life of 5 years. The company uses the Net Present Value (NPV) method to evaluate capital budgeting projects and its discount rate is 9%.

Project A         Project B         Project C

Initial cash outlay (cost)                     -$5,000,000     -$6,000,000     -$2,500,000

Cash inflows per year                           $1,500,000    $1,800,000     $600,000

Residual value                                       $ 500,000              0                $100,000

1. If the projects are mutually exclusive, which, if any, should the company accept?  Why?

2. If the projects are independent, which, if any, should the company accept?  Why?

3. One of the company’s managers states “To me, no matter what else we do, Project C needs to be our first choice because it has the lowest initial cost of $2,500,000.”  Comment on this manager’s proposal, considering the concepts of NPV and Payback Method.

Answer 1

	CALCULATION OF NPV:	Project A	Project B	Project C
	Initial cost	$ -50,00,000	$ -60,00,000	$ -25,00,000
	Cash inflows per year	$   15,00,000	$   18,00,000	$     6,00,000
	Residual value	$      5,00,000	$                  -	$     1,00,000
	PVIFA[9,5]	3.88965	3.88965	3.88965
	PVIF[9,5]	0.64993	0.64993	0.64993
	PV of cash inflows	$   58,34,475	$   70,01,370	$   23,33,790
	PV of residual value	$      3,24,965	$                  -	$         64,993
	Sum of PVs	$   61,59,440	$   70,01,370	$   23,98,783
	Less: Initial cost	$ -50,00,000	$ -60,00,000	$ -25,00,000
	NPV	$   11,59,440	$   10,01,370	$   -1,01,217
	PAYBACK PERIOD: [in years]
	Initial cost/Annual cash flow	3.33	3.33	4.17
	ANSWERS:
1]	If the projects are mutually exclusive, Project A should be accepted as it has the
	highest NPV.
2]	It the projects are independent, the firm should accept Project A and Project B as
	they have positive NPV.
3]	Lowest initial cost is not the criterion. Project C has the highest payback period
	and a negative NPV. Hence, it is to be rejected. Even if it has a lower payback
	period, it should be rejected as it has a negative NPV.