Question

A firm utilizes a strategy of capital rationing, which is currently $375,000 and is considering the following two projects: Project A has a cost of $335,000 and the following cash flows: year 1 $140,000; year 2 $150,000; and year 3 $100,000. Project B has a cost of $365,000 and the following cash flows: year 1 $220,000; year 2 $110,000; and year 3 $150,000. Using a 6% cost of capital, which decision should the financial manager make?

Answer 1

Answer:

The manager should pick project B

Explanation:

To determine what decision the manager should make, the NPV of both projects should be calculated.

Net present value is the present value of after tax cash flows from an investment less the amount invested.

NPV can be calculated using a financial calculator

NPV for project A

Cash flows:

Year 0 = $-335,000

year 1 = $140,000

year 2 = $150,000

year 3 = $100,000

I = 6%

NPV= $14,536.87

NPV for project B

Cash flows:

Year 0 = $-365,000

year 1 = $220,000

year 2 = $110,000

year 3 = $150,000

I = 6%

NPV= $66,389.67

Both projects are profitable but because the firm uses capital rationing , the manager has to pick the now profitbale project, which is project B.

To find the NPV using a financial calacutor:

1. Input the cash flow values by pressing the CF button. After inputting the value, press enter and the arrow facing a downward direction.

2. After inputting all the cash flows, press the NPV button, input the value for I, press enter and the arrow facing a downward direction.

3. Press compute

I hope my answer helps you