Question

The Computer Games Division of Entertainment, Inc. is considering two investment projects, each of which has an up-front expenditure of $30,000. You estimate that the cost of capital is 9 percent and that the investments will produce the following after-tax cash inflows:

Year	Project A	Project B
1	6,000	22,000
2	12,000	16,000
3	16,000	12,000
4	22,000	6,000

Prepare answers to the following questions. Please show your calculations.

3. If the two projects are independent and the cost of capital is 9 percent, which project or projects should

Entertainment, Inc. undertake?

4. If the two projects are mutually exclusive and the cost of capital is 9 percent, which project should

Entertainment, Inc. undertake? (Hint: With mutually exclusive projects

Answer 1

Given that the initial investment for each of the projects is $30,000 and the cost of capital is 9%.
Cash flows are given by:
Project A:
Year 0:$30,000
Year 1:$6,000
Year 2:$12,000
Year 3:$16,000
Year 4:$22,000

We need to calculate the net present value.
Net present value (NPV)=-Initial cash flow + Present value of future cash flows
Present value of future cash flows= Cash flow in year 1/(1+ Cost of capital)^1+Cash flow in year 2/(1+ Cost of capital)^2+Cash flow in year 3/(1+ Cost of capital)^3+Cash flow in year 4/(1+ Cost of capital)^4
NPV=-$30,000+$6,000/(1+9%)^1+$12,000/(1+9%)^2+$16,000/(1+9%)^3+$22,000/(1+9%)^4
=-$30,000+$6,000/(1.09)^1+$12,000/(1.09)^2+$16,000/(1.09)^3+$22,000/(1.09)^4
=-$30,000+$6,000/1.09+$12,000/1.1881+$16,000/1.295029+$22,000/1.41158161
=-$30,000+$5504.587156+$10100.15992+$12354.93568+$15585.35464
=$13545.0374

NPV of project A at a cost of capital of 9% is $13545.0374

Project B:
Year 0:$30,000
Year 1:$22,000
Year 2:$16,000
Year 3:$12,000
Year 4:$6,000

NPV=-$30,000+$22,000/(1+9%)^1+$16,000/(1+9%)^2+$12,000/(1+9%)^3+$6,000/(1+9%)^4
=-$30,000+$22,000/(1.09)^1+$16,000/(1.09)^2+$12,000/(1.09)^3+$6,000/(1.09)^4
=-$30,000+$22,000/1.09+$16,000/1.1881+$12,000/1.295029+$6,000/1.41158161
=-$30,000+$20183.48624+$13466.87989+$9266.201761+$4250.551266
=$17167.11916

NPV of project B at a cost of capital of 9% is $17167.11916

Part 3:
All the independent projects that satisfy the criteria of capital budgeting should be accepted.
NPV decision rule: All the projects with NPV>0 should be accepted.
As the NPV of both the projects are greater than zero, both the projects should be accepted.

Part 4:
In case of mutually exclusive projects, only one project can be selected out of a set of projects. The project with higher NPV should be accepted.
NPV of project B is higher, so project B should be accepted.