Question

Suppose your boss has asked you to analyze two mutually exclusive projects - Project A and Project B. Both projects require the same investment amount, and the sum of cash inflows of Project A is larger than the sum of cash inflows of Project B. A coworker told you that you do not need to do an NPV analysis of the projects because you already know that Project A will have a larger NPV than Project B. Do you agree with your coworker's statement?

a. Yes, Project A will always have the largest NPV, because its cash inflows are greater than Project B's cash inflows.


b. No, the NPV calculation will take into account not only the project's cash inflows but also the timing of cash inflows and outflows. Consequently, Project B could have a larger NPV than Project A, even though Project A has larger cash inflows.


c. No, the NPV calculation is based on percentage returns. So, the size of the project's cash flows does not affect a project's NPV.

Answer 1

b. No, the NPV calculation will take into account not only the project's cash inflows but also the timing of cash inflows and outflows. Consequently, Project B could have a larger NPV than Project A, even though Project A has larger cash inflows.

Step-by-step explanation:

The net present value is the present value of after tax cash flows from an investment less the amount invested.

An example:

Suppose there are two projects with a cash outlay of $500.

The cash flow for project A :

Cash flow from year 1 to 3 =$0

Cash flow from year 4 to 7 =$ 500

WACC = 10%

Using a financial calculator, the NPV =$690.78

The cash flow for project B

Cash flow for year one and two =$300

Cash flow for year three = $100

Cash flow for year four and five =$500

WACC = 10%

using a financial calculator, the NPV = $747.76

From this example, even though the cash flow from project A is higher than the cash flow from project B, project B's NPV is higher.

I hope my answer helps you.