Question

Which mutually exclusive project would you select, if both are priced at $1,000 and your required return is 15%: Project A with three annual cash flows of $1,000; or Project B, with 3 years of zero cash flow followed by 3 years of $1,500 annually? Project A Project B Neither project should be selected. You are indifferent since the NPVs are equal.

Answer 1

Answer:

Project A

Explanation:

Mutually exclusive projects are projects that cannot be executed together. Therefore, only one has to be chosen. To decide which one to choose between Project A and Project, we have to calculate their net present value as follows:

Calculation of NPV of Project A

Year (n)   Cash Flow ($)   DF = 1/(1.15)^n         PV ($) 

Year 0       (1,000.00)             1.0000            (1,000.00)

Year 1        1,000.00             0.8696                 869.57  

Year 2        1,000.00              0.7561                  756.14  

Year 3        1,000.00             0.6575                  657.52  

                                               Project A NPV = 1,283.23

Calculation of NPV of Project B

Year (n)   Cash Flow ($)     DF = (1.15)^n        PV ($) 

Year 0       (1,000)                  1.0000            (1,000.00)

Year 1             0                      0.8696                  0  

Year 2            0                       0.7561                   0  

Year 3             0                      0.6575                  0    

Year 4        1,500                      0.5718              857.63  

Year 5        1,500                     0.4972              745.77  

Year 6        1,500                     0.4323              648.49  

                                             Project B NPV = 1,251.89

Since the $1,283.23 net present value (NPC) of Project A is greater than the $1,251.89 NPV of project B, project A should be chosen.