Question

A firm with a WACC of 10% is considering the following mutually exclusive projects:

0 1 2 3 4 5
Project 1 -$200 $60 $60 $60 $220 $220
Project 2 -$600 $300 $300 $100 $100 $100

Which project would you recommend?

a. Project 2, since the NPV2 > NPV1.
b. Both Projects 1 and 2, since both projects have NPV's > 0.
c. Neither A or B, since each project's NPV < 0.
d. Both Projects 1 and 2, since both projects have IRR's > 0.
e. Project 1, since the NPV1 > NPV2.

Answer 1

Option e is the correct answer.

As the NPV of project 1 is higher than Project 2's NPV, Project 1 is recommended,

Step-by-step explanation:

To determine which project to choose, we will calculate the net present value (NPV) of both projects and the project with the higher NPV will be chosen.

NPV is the present value of the future cash flows inflows expected from the project less any initial cost. The formula for NPV is as follows,

NPV = CF1 / (1+WACC) + CF2 / (1+WACC)^2 + ... + CFn / (1+WACC)^n - Initial outlay

Where,

• CF1, CF2,... is the cash flow in year 1, Year 2 and so on

NPV - Project 1 = 60 / (1+0.1) + 60 / (1+0.1)^2 + 60 / (1+0.1)^3 +

220 / (1+0.1)^4 + 220 / (1+0.1)^5 - 200

NPV - Project 1 = $236.076 rounded off to $236.08

NPV - Project 22 = 300 / (1+0.1) + 300 / (1+0.1)^2 + 100 / (1+0.1)^3 +

100 / (1+0.1)^4 + 100 / (1+0.1)^5 - 600

NPV - Project 2 = $126.1861 rounded off to $126.19

As the NPV of project 1 is higher than Project 2's NPV, Project 1 is recommended,