Question

We have two independent and mutually exclusive projects, A and B. Project A requires an initial investment of $1000, and will yield $500 of cash inflows for the next three years. Project B requires an initial investment of $3,500, and will yield $1,000 of cash inflows for the next five years. The required return on both projects is 10%.                                                                                                      (13 marks total)

a. What are the net present values of Project A and Project B?
b. What is the problem with using the NPV investment criterion in this case? What alternative criterion should be used? (1 mark)
c. Which project should be chosen?
d. What is the real rate of return based on the exact Fisher equation? (1 mark)
e. What are the real cash flows from Project A and Project B?
f. What are the real net present values of Project A and Project B? (Hint: The real NPV should be the same as the nominal NPV.)
g. Which project should be chosen based on the real cash flows and real rate of return?

Can i please have a detailed answer for each part of this question (a - g) thank you.

Answer 1

Given
	Project A	Project B
Initial Investment	($1,000)	($3,500)
Yield
Year-1	$500	$1,000
Year-2	$500	$1,000
Year-3	$500	$1,000
Year-4	$0	$1,000
Year-5	$0	$1,000
a)
Net present value of projects :-
	Project -A		Project -B
Present value of cash outflows
Y-0	($1,000)		($3,500)
Present value of cash inflows
Y1-3	$500		-
Y1-5	$0		$1,000
Discount rate	10%		10%
Present value factor(10%,3)	2.496		3.79079
	$1,248		$3,790.79
NPV	Present value of cash inflows-Present value of cash outflows
	$1248-$1000		$3,791-$3500
	$248		$291
C)
In case of NPV, the project B is better to invest
d)
in question inflation rate not given.
Assuming inflation rate as 5%
Real interest rate= nominal interest rate - inflation rate
=	10%-5%
=	5%
e)
Real cash flows
	Project A					Project B
=	Nominal cash flows - inflation rate
Y-0	$1000-5%	$950				$3,500-5%	$3,325
Y1-3	$500-5%	$475
Y1-5						$1000-5%	$950