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Assume that your firm wants to choose between two project options:
Project A: Br. 500,000 invested today will yield an expected income stream of Br150, 000 per year for 5 years, starting in Year 1.
Project B: an initial investment of Br 400,000 is expected to produce this revenue stream: Year 1 = 0, Year 2 = Br 50,000, Year 3 = Br 200,000, Year 4 = Br300, 000, and Year 5 = Br200, 000. Assume that a required rate of return for your company is 10% and that inflation is expected to remain steady at 3% for the life of the project. Which is the better investment? Why?

Sagot :

Parrain

Answer: Project B should be chosen as it has a higher NPV of $70,314.97

Explanation:

You need to find the Net Present Value of both projects. The better investment is the one with a higher Net Present Value.

As there will be inflation, this needs to be included in the required return:

= 10% + 3%

= 13%

This will be the rate for discounting.

Project A:

Net Present Value = Present value of cash inflows - Cash invested

Present value of cash inflows:

This is a constant inflow so is an annuity. Present value will be:

= Amount * Present value interest factor of annuity, 5 years, 13%

= 150,000 * 3.5172

= $527,580

Net Present value = 527,580 - 500,000

= $27,580

Project B:

Net Present Value = Present value of cash inflows - Cash invested

= 50,000 / (1 + 13%)² + 200,000 / 1.13³ + 300,000 / 1.13⁴ + 200,000 / 1.13⁵ - 400,000

= 470,314.97 - 400,000

= $70,314.97

Project B should be chosen as it has higher NPV.

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