Question

Project S requires an initial outlay at t = 0 of $11,000, and its expected cash flows would be $5,000 per year for 5 years. Mutually exclusive Project L requires an initial outlay at t = 0 of $26,500, and its expected cash flows would be $11,950 per year for 5 years. If both projects have a WACC of 12%, which project would you recommend?

Select the correct answer:

a. Neither Project S nor L, since each project's NPV < 0.

b. Project S, since the NPVS > NPVL.

c. Both Projects S and L, since both projects have NPV's > 0.

d. Project L, since the NPVL > NPVS.

e. Both Projects S and L, since both projects have IRR's > 0.

Answer 1

Answer :

Project S

Year	Project cash flows (i)	DF @ 12%	DF @ 12%	PV of Project [ (i) * (ii) ]
0	- 11,000	1	1	- 11,000
1	5,000	1 / [ 1 + 12% )^1 ]	0.89286	4,464.30
2	5,000	1 / [ 1 + 12% )^2 ]	0.79719	3,985.95
3	5,000	1 / [ 1 + 12% )^3 ]	0.71178	3,558.90
4	5,000	1 / [ 1 + 12% )^4 ]	0.63552	3,177.60
5	5,000	1 / [ 1 + 12% )^5 ]	0.56743	2,837.15
			NPV =>	7,023.90

Project L

Year	Project cash flows (i)	DF @ 12%	DF @ 12%	PV of Project [ (i) * (ii) ]
0	- 26,500	1	1	- 26,500
1	11,950	1 / [ 1 + 12% )^1 ]	0.89286	10,669.68
2	11,950	1 / [ 1 + 12% )^2 ]	0.79719	9,526.42
3	11,950	1 / [ 1 + 12% )^3 ]	0.71178	8,505.77
4	11,950	1 / [ 1 + 12% )^4 ]	0.63552	7,594.46
5	11,950	1 / [ 1 + 12% )^5 ]	0.56743	6,780.79
			NPV =>	16,577.12

If projects are mutually exclusive then only one project can be selected. In this case, NPV of project L is more than NPV of project S. So, we must select project L.

Therefore, the answer is option (d) i.e., Project L, since the NPVL > NPVS.