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:

0

1

2

3

4

Project S	-$1,000	$896.96	$240	$5	$5
Project L	-$1,000	$5	$260	$400	$764.90

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.

Answer 1

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).