Question

Consolidated Inc. uses a weighted average cost of capital of 12% to evaluate average-risk projects and adds/subtracts two percentage points to evaluate projects of greater/lesser risk. Currently, two mutually exclusive projects are under consideration. Both have a cost of $200,000 and last four years. Project A, which is riskier than average, will produce annual after-tax cash flows of $71,000. Project B, which has less-than-average risk, will produce after-tax cash flows of $146,000 in Years 3 and 4 only. What should Consolidated do?

Answer 1

Ans. Consolidated inc. should select project a) NPV=6,873.57 even though the Net present value of B) is higher (NPV(B)=9,411.93. If both projects were discounted at the same rate (12%), A) would be higher than B.

Step-by-step explanation:

hi, in order to decide between one of the two projects we have to find the net present value of each (NPV). Whichever is higher could be the best alternative. The problem here is that if they both were discounted at 12%, project B would have a negative NPV (NPV(B)= -$3,294.44) and project A would have a NPV of $15,651.80.

Let´s do the math for the net present value.

`NPV(A)=-200000+(71000((1+0.14)^(4)-1) )/(0.14(1+0.14)^(4) ) =6873.57`

`NPV(B)=-200000+(146000)/((1+0.10)^(3) ) +(146000)/((1+0.10)^(4) ) =9411.93`

Normally, we would have picked project B) but there is a reason why this project is showing a higher NPV, its discount rate is lower, and if they both were equally risky, project A would outperform project B.

Even though this is my appreciation, you are free to think otherwise, for this is a problem that allows you to select an answer, based on your calculations and your risk averse profile. You could also say that put your money in a safe place is always the best choice, so you could have chosen B.

Best of luck.