Question

Consider two mutually exclusive projects with the following cash flows:

	Project A	Project B
Time 0	-10,000	-10,000
Time 1	5,000	4,000
Time 2	5,000	3,000
Time 3	2,000	6,000

At a cost of capital of 8%, which project should the company choose? Explain which decision rule you should use in this case.

Answer 1

Net Present Value (NPV) of PROJECT-A

Year	Annual cash inflow ($)	Present Value factor at 8.00%	Present Value of Annual cash inflow ($)
1	5,000	0.92593	4,629.63
2	5,000	0.85734	4,286.69
3	2,000	0.79383	1,587.66
TOTAL			10,503.99

Net Present Value = Present Value of annual cash inflows - Initial Investment

= $10,503.99 - $10,000

= $503.99

Net Present Value (NPV) of PROJECT-B

Year	Annual cash inflow ($)	Present Value factor at 8.00%	Present Value of Annual cash inflow ($)
1	4,000	0.92593	3,703.70
2	3,000	0.85734	2,572.02
3	6,000	0.79383	4,762.99
TOTAL			11,038.71

Net Present Value = Present Value of annual cash inflows - Initial Investment

= $11,038.71 - $10,000

= $1,038.71

DECISION

Evaluation of Investment proposal using NPV Decision Rule

If the Projects are mutually exclusive, then the Project with the higher Net Present Value should be selected. Here, the Project-A has the higher NPV of $1,038.71 as compared to the NPV of Project-B. Therefore, the firm should “Accept Project-A”

NOTE

The formula for calculating the Present Value Inflow Factor (PVIF) is [1 / (1 + r)ⁿ], where “r” is the Discount Rate/Cost of capital and “n” is the number of years.