Question

Wilson’s Market is considering two mutually exclusive projects that will not be repeated. The required rate of return is 13.9 percent for Project A and 12.5 percent for Project B. Project A has an initial cost of $54,500, and should produce cash inflows of $16,400, $28,900, and $31,700 for Years 1 to 3, respectively. Project B has an initial cost of $69,400, and should produce cash inflows of $0, $48,300, and $42,100, for Years 1 to 3, respectively. Which project, or projects, if either, should be accepted and why?

Answer 1

Answer:

Project A shall be accepted as Project A has positive and higher NPV than Project B.

Explanation:

Since the projects are mutually exclusive we will evaluate the NPV that is Net present value of the projects.

Project A

Present Value of Cash outflow = $54,500

Rate of return = 13.9%

Present value of cash inflows

Year            Cash flow            PV @13.9%              Present Value

1                    $16,400                0.878                         $14,399.2

2                   $28,900               0.771                           $22,281.9

3                   $31,700                 0.677                          $21,460.9

Total cash inflow $58,142

NPV = $58,142 - $54,500 = $3,642

Project B

Present Value of Cash outflow = $69,400

Rate of return = 12.5%

Present value of cash inflows

Year            Cash flow            PV @ 12.5%              Present Value

1                    $0                          0.888                          $0

2                   $48,300                0.790                           $38,157

3                   $42,100                 0.702                          $29,554.2

Total cash inflow $67,711.2

NPV = $67,711.2 - $69,400 = -$1,688.8

Since NPV of Project B is negative and that of project A is positive Project A shall be selected, as there will be loss in case of Project B.