Question

Leslie is charged with determining which small projects should be funded. Along with this assignment, she has been granted the use of $15,000 for a maximum of two years on a discounted basis. She is considering three projects. Project A costs $7,500 and has cash flows of $4,000 a year for Years 1 to 3. Project B costs $8,000 and has cash flows of $3,000, $4,000, and $3,000 for Years 1 to 3, respectively. Project C costs $2,000 and has a cash inflow of $2,500 in Year 2. What decisions should she make regarding these projects if she assigns them a mandatory discount rate of 8.5 percent? Explain why.

Answer 1

Answer:

The answer is: Leslie should fund projects A and C

Explanation:

In order to determine if a project should be accepted, the first thing Leslie has to do is determine the projects´ Net Present Value (NPV). If the NPV is 0 or more, then the projects could be funded.  

The formula to calculate NPV is:

             NPV = ∑{p/( 1+r)t} - C

• p = net cash flows from the period
• r = discount rate (8.5% in this case)
• t = number of periods
• c = capital invested

Project A:

p = $4000;$4000;$4000

r = 8.5%

t = 3

c = $7,500

The NPV for Project A is $2,716.09

Project B:

p = $3000;$4000;$3000

r = 8.5%

t = 3

c = $8,000

The NPV for Project B is $511.52

Project C:

p = $0;$2,500

r = 8.5%

t = 2

c = $2,000

The NPV for Project C is $123.64

Once you calculate the NPVs from projects A,B and C you must determine how to distribute the $15,000 available. All three projects have positive NPVs, so they are profitable. But you can´t fund projects A and B since their combined costs ($7,500 + $8,000 = $15,500) exceeds $15,000. Leslie should invest in project A since its NPV is higher ($2,716.09 ˃ $511.52). She should also fund project C since its NPV is positive ($123.64) and the capital needed is smaller (only $2,000).