Question

Consider the following projects, X and Y, where the firm can only choose one. Project X costs $600 and has cash flows of $400 in each of the next 2 years. Project B also costs $600, and generates cash flows of $500 and $275 for the next 2 years, respectively. Which investment should the firm choose if the cost of capital is 10 percent?

A) Neither.
B) Project X.
C) Project Y.
D) Not enough information to tell.

Answer 1

The firm should choose Project X because it has a positive net present value (NPV) of $94.22, while Project Y has a negative NPV of -$138.84.

Step-by-step explanation:

To determine which investment the firm should choose, we need to calculate the net present value (NPV) of each project. NPV is the present value of the cash flows of a project, discounted at the firm's cost of capital.

For Project X:

NPV = -$600 + (PV of $400 for 2 years) = -$600 + ($400 / (1 + 0.10)^1 + $400 / (1 + 0.10)^2) = -$600 + ($363.64 + $330.58) = $94.22

For Project Y:

NPV = -$600 + (PV of $500 for 1 year) + (PV of $275 for 2 years) = -$600 + ($500 / (1 + 0.10)^1 + $275 / (1 + 0.10)^2) = -$600 + ($454.55 + $206.61) = -$138.84

Therefore, the firm should choose Project X since it has a positive NPV ($94.22) while Project Y has a negative NPV (-$138.84).