Question

Given the following cash flows for a two mutually exclusive projects (A&B) and assuming 16% cost of capital; answer the next 2 questions:

year	Project A	Project B
0	-5000	-1000
1	2500	600
2	2500	600
3	2500	600

1)  Which project should be accepted, if any and why?

		Project B; it has a higher IRR and PI
		Neither project should be accepted, they both have negative NPVs
		Both project should be accepted; they have IRRs greater than the cost of capital
		Project A; it has the higher positive NPV
		Not enough information to answer.

Answer 1

A:

Present value of inflows=cash inflow*Present value of discounting factor(rate%,time period)

=2500/1.16+2500/1.16^2+2500/1.16^3

=5614.72

NPV=Present value of inflows-Present value of outflows  

=5614.72-5000

=$614.72(Approx)

B:

Present value of inflows=cash inflow*Present value of discounting factor(rate%,time period)

=600/1.16+600/1.16^2+600/1.16^3

=1347.53

NPV=Present value of inflows-Present value of outflows  

=1347.53-1000

=$347.53(Approx)

Hence since projects are mutually exclusive;project must be selected having higher NPV as it would lead to higher value addition to the firm(Project A)

Hence the correct option is:

Project A; it has the higher positive NPV