Question

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A company is considering three capital budgeting projects. Data relative to each is given below. Each project has a life of 5 years. The company uses the NPV method to evaluate capital budgeting projects and its discount rate is 9%.

	Project A	Project B	Project C
Initial cash outlay (cost)	-$5,000,000	-$6,000,000	-$3,000,000
Cash inflows per year	$1,500,000	$1,800,000	$ 600,000
Residual value	$   500,000	0	$100,000

QUESTIONS

1. If the projects are mutually exclusive, which, if any, should the company accept? Why?
2. If the projects are independent, which, if any, should the company accept? Why?
3. One of the company’s managers states “To me, no matter what else we do, Project C needs to be our first choice because it has the lowest initial cost of $3,000,000.” Comment on this manager’s proposal, considering the tenets of NPV.

Answer 1

Interest	0
Year	Project A	Project B	Project C	PV factor	PV Project A	PV Project B	PV Project C
0	(5,000,000)	(6,000,000)	(3,000,000)	1.000	(5,000,000)	(6,000,000)	(3,000,000)
1	1,500,000	1,800,000	600,000	0.917	1,375,500	1,650,600	550,200
2	1,500,000	1,800,000	600,000	0.842	1,263,000	1,515,600	505,200
3	1,500,000	1,800,000	600,000	0.772	1,158,000	1,389,600	463,200
4	1,500,000	1,800,000	600,000	0.708	1,062,000	1,274,400	424,800
5	1,500,000	1,800,000	600,000	0.650	975,000	1,170,000	390,000
5	500,000	-	100,000	0.650	325,000	-	65,000
				NPV	1,158,500	1,000,200	(601,600)
Mutually Exclusive projects, Project A should be accepted as NPV if highest
Indiependent projects, Preference order is to take up project A first and then Project B. Project C should be rejected
as this is giving negative PV
Manager proposal should be rejected as NPV is negative