A3Q5 We have two independent and mutually exclusive projects, A and B. Project A
ID: 2807475 • Letter: A
Question
A3Q5
We have two independent and mutually exclusive projects, A and B. Project A requires an initial investment of $1000, and will yield $500 of cash inflows for the next three years. Project B requires an initial investment of $3,500, and will yield $1,000 of cash inflows for the next five years. The required return on both projects is 10%.
a. What are the net present values of Project A and Project B?
b. What is the problem with using the NPV investment criterion in this case? What alternative criterion should be used?
c. Which project should be chosen?
The cash flows and required return given are all in nominal terms. Given that the inflation rate is 3%, answer the following questions:
d. What is the real rate of return based on the exact Fisher equation?
e. What are the real cash flows from Project A and Project B?
f. What are the real net present values of Project A and Project B? (Hint: The real NPV should be the same as the nominal NPV.)
g. Which project should be chosen based on the real cash flows and real rate of return?
Explanation / Answer
a). Solution :- Net present value (NPV) = Present value of cash inflows - Present value of cash outflow.
Project A
Present value of cash inflows = 500 * [ 1 - (1.10)-3 ] / 0.10
= 500 * [ 1 - 0.7513 ] / 0.10
= 500 * 0.2487 / 0.10
= 500 * 2.487
= $ 1243.50
Present value of cash outflow = $ 1000.
Net present value of Project A = 1243.50 - 1000
= $ 243.50
Project B
Present value of cash inflows = 1000 * [ 1 - (1.10)-5 ] / 0.10
= 1000 * [ 1 - 0.6209 ] / 0.10
= 1000 * 0.3791 / 0.10
= 1000 * 3.791
= $ 3791.
Present value of cash outflow = $ 3500.
Net present value of Project B = 3791 - 3500
= $ 291.
Conclusion :-
b). Solution :- Project A and Project B both yield positive net present value (NPV). Since the two projects are independent, accordingly, both the projects should be accepted as per the NPV investment criterion. Accordingly, The main problem of using NPV investment criterion in the given question is that both the projects (Project A and Project B) are to selected according to the net present value (NPV) approach.
The alternative investment criterion to applied in the given question for evaluating the two projects would be the internal rate of return (IRR) approach in capital budgeting in the finance.
c). Answer :- Since the net present value (NPV) of Project B is more than the net present value (NPV) of Project A, accordingly, Project B should be choosen as it will generate more wealth for investors in the long-run.
Net present value of Project A $ 243.50 Net present value of Project B $ 291.00