Question

A company has two projects to choose from, either option will be repeated when its lifetime is over (i.e., once you choose one, you will use that option forever).

Option A costs $10K and lasts 3 years and option B costs $18K and lasts 6 years. Prices are going up by 2% per year (that is, initial costs go up at the inflation rate). A company funds itself with half debt and half equity where debt costs 5% and equity costs twice as much (ignore taxes).

Company’s last rejected project had an IRR of 7%. Which option should this company pick?

Answer 1

The best option the company should pick is Option B

Because after doing the calculations of Inflation rates and considering the equity and debt costs, option B costs less as compared to the option A.

After Inflation:

Option A = 3.4K per year, whereas

Option B = 3.15K per year.