Question

Q) Consider the following cash flow on two mutually exclusive projects.

Year	Project A (Rs)	Project B(Rs)
0	-40000	-50000
1	20000	10000
2	15000	20000
3	15000	40000

The cash flow of project A are expressed in real terms while those of project B are expressed in nominal terms.The appropriate nominal discount rate is 15% and the inflation rate is 4%. Which project should be choosen.

Answer 1

As the two projects are mutually exclusive only one can be taken up by the firm. The selection for the same should be done by comparing the NPVs of the two projects.The one that generates greater positive NPV should be selected. However, a major consistency to be maintained while making this comparison is that cash flows for both projects should be either in real term or nominal terms. Since that is not the question one needs to convert either Project A's cash flows into nominal terms or Project B's cash flows into real terms. Addtionally, if the cash flows are in say nominal terms so should be the discount rate and likewise for the real cash flow sceario. In this question we shall proceed by converting Project A's cash flows into nominal terms by inflating them using the given annual inflation rate, followed by discounting them using the nominal discount rate and then comparing their respective NPVs. The current time period is at the end of Year 0 (Present Time). Hence, the initial investment at end of year 0 need not be adjusted for inlfation or its real and nominal values are same. The remaining calculations are in the EXCEL Screenshots given below

NOTE: Nominal Cash Flow is one which is NOT adjusted for inflation and Real Cash Flow is one which is adjusted (or reduced by) for inflation.

As Project A generates greater positive NPV in nominal terms and the projects are mutually exclusive, Project A should be chosen. Additionally, an analysis in real terms would also have returned the same verdict.