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Hi all! can somebody please explain what I am missing here?
·A company is considering two mutually exclusive projects. The cash flows for each project are as follows:
Project X Year0 $ (15,000) Year1 $8,000 Year2 $8,000 Year3 $8,000
Project Y Year0 $ (15,000) Year 3 $26,000
The company evaluates projects using the net present value method and uses a cost of capital of 10%.
Which project(s) should the company undertake?
A Both projects
B Project X only
C Project Y only
D Neither projectSo, I thought the correct answer was C. But instead of using the NPV factor for 10% in both projects. They use the NPV factor for one and the annuity factor for the other (I think). So this is the answer that they give:
The candidate therefore needs to
calculate the net present value of both projects:
NPV of X = ($15,000) + 2.487 x $8,000 = $4,896
NPV of Y = ($15,000) + 0.751 x $26,000 = $4,526
Note that in doing the calculation, I have used annuity factors, which are a valuable tool when
answering questions under exam time pressure, and yet this is a technique few candidates
generally use in Section B questions.¿……?
Can I confirm answer B is the one given?If they were not mutually exclusive and in the absence of any other constraint, both projects would be chosen as both have positive NPV. The examiner is able to use annuity in this case because equal amount of 8000 is inflow every year of project X. If unequal amounts inflowed each year it would not be possible to use annuity factor. Hope this helps.
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