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

Year	Project-A	Project-B	Project-C	PV factor @ 9%	PV-A	PV-B	PV-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	1,376,147	1,651,376	550,459
2	1,500,000	1,800,000	600,000	0.842	1,262,520	1,515,024	505,008
3	1,500,000	1,800,000	600,000	0.772	1,158,275	1,389,930	463,310
4	1,500,000	1,800,000	600,000	0.708	1,062,638	1,275,165	425,055
5	1,500,000	1,800,000	600,000	0.650	974,897	1,169,876	389,959
5	500,000	-	100,000	0.650	324,966	-	64,993
				NPV	1,159,443	1,001,372	(601,216)
				PV of inflows	6,159,443	7,001,372	2,398,784
				PV of otflows	5,000,000	6,000,000	3,000,000
				Profitability ratio	1.232	1.167	0.800
Since NPV is highest in Project A, that should be accepted
Since NPV and PI both are highest in Project A, then project A should be accepted
Though Project C has lowest initial investment but over the project period, the project is creating negative NPV.
Its PI ratio is also less than 1 and hence on NPV grounds, project C should not be accepted