Consider two projects: Project A currently costs $15 million, which is to be paid this year. The returns are $12 million after in one year and $11 million in two years. Project B currently costs $13 million, again to be paid this year. The returns are $10 million after in one year and $8 million in two years.

At an interest rate of 6%, the net present value of Project A is roughly , while the net present value of Project B is roughly .

Suppose investing in one project eliminates the opportunity to invest in the other. If the interest rate is 6%, Project is preferable.

Question

06-12-2019
Business

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Consider two projects: Project A currently costs $15 million, which is to be paid this year. The returns are $12 million after in one year and $11 million in two years. Project B currently costs $13 million, again to be paid this year. The returns are $10 million after in one year and $8 million in two years.

At an interest rate of 6%, the net present value of Project A is roughly , while the net present value of Project B is roughly .

Suppose investing in one project eliminates the opportunity to invest in the other. If the interest rate is 6%, Project is preferable.

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sofiasuarez1307 sofiasuarez1307 · Answer 1 · 2019-12-09T02:15:54+01:00

Answer:

Because the NPV of project A is higher, this project is preferable than project B.

Explanation:

The net present value (NPV) is the sum of all cash flows in present value discounted at a rate (known as discount rate, cost of capital or WACC)

A company will never choose a project with a NPV that is negative because the company will not only recover the investment it will destroy value. A project with an NPV of 0 will recover the initial investment but will not generate other revenue, it will not create or destroy value. And a project with positive NPV is attractive for investors and the higher the NPV the best is the project.

To calculate the NPV you use the formula attached, but you can do it faster in excel:

First, you copy all cash flows including the investment with a negative sign.

For example, for project A:

year 0: -$15,000,000

year 1: $12,000,000

year 2: $11,000,000

Then we use the financial formula "NPV" in this way:

"=NPV(6%;C5:C6)+C4"= $1283,23

C5 is: $12,000,000

C6 is: $11,000,000

C4 is: -$15,000,000

And because the investment is to be paid this year and this value is already in present value, we sum it.

We do the same procedure to obtain the NPV for project B.

According to the results attached (excel table) project A has an NPV of $6,110,716 and project B has an NPV of $3,553,934. Because the NPV of project A is higher, this project is preferable than project B.