Question

Capital budgeting criteria: mutually exclusive projects

A firm with a WACC of 10% is considering the following mutually exclusive projects:

Project A	-$300	$75	$75	$75	$220	$220
Project B	-$550	$250	$250	$80	$80	$80

Which project would you recommend?

Select the correct answer.

I. Both Projects A and B, since both projects have IRR's > 0.

II. Project A, since the NPVA > NPVB.

III. Project B, since the NPVB > NPVA.

IV. Neither A or B, since each project's NPV < 0.

V. Both Projects A and B, since both projects have NPV's > 0.

Answer 1

Dear Student,

The concept tested in the question is the capital budgeting techniques.

Here is the solution :

1) Calculation of NPV

> Project A

Year	Cashflow	Present Value @ 10%
0	-300	-300
1	75	68.18
2	75	69.18
3	75	56.35
4	220	150.26
5	220	136.60
	NPV	173.38

> Project B

Year	Cashflow	Present Value @ 10%
0	-550	-550
1	250	227.27
2	250	206.61
3	80	60.11
4	80	54.64
5	80	49.67
	NPV	48.30

2) Answer

Option	Correct or not	Reason
I	Incorrect	Both projects cannot be selected since projects are mutually exclusive. In capital budgeting, mutually-exclusive projects refer to a set of projects out of which only one project can be selected for investment. A decision to undertake one project from mutually exclusive projects excludes all other projects from consideration. Hence this option is incorrect.
II	Correct	Since NPV of Project A is $ 173.38 which is more than the project B. Hence this option is correct and investment should be made in Project A.
III	Incorrect	Since project B NPV is less than project, this option is not correct.
IV	Incorrect	The option is correct as both the projects have NPV >0. Hence this option is incorrect.
V	Incorrect	Both projects cannot be selected since projects are mutually exclusive. In capital budgeting, mutually-exclusive projects refer to a set of projects out of which only one project can be selected for investment. A decision to undertake one project from mutually exclusive projects excludes all other projects from consideration. Hence this option is incorrect.