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Alpha Inc. has the following two projects that it is considering, and it wants to choose one....

Question:

Alpha Inc. has the following two projects that it is considering, and it wants to choose one. Project A has an investment outlay/expense today of $1,040, and its cash flows over the next three years are $510, $610, and $750. Project B has an outlay of $2,080, and cash flows of $970, $1,290, and $1,480.

Which project should Alpha choose? (You can assume no taxes.)

Net Present Value:

The net present value of an investment is defined as the change in the wealth of the investors of firm if the investment is undertaken. A project is accepted for investment only if the calculated net present value is greater than zero. For mutually exclusive projects, the net present value method over other capital budgeting techniques.

Answer and Explanation:

Project A

The net present value of the project can be calculated by deducting the outlay from the sum of present values of all the prospective cash flows where the discount factor consists of assumed interest rate of 12% (0.12) and its exponential power indicates the timing of the respective cash flow as shown below:

Net present value:

  • {eq}= \dfrac{\$510}{1.12^1} + \dfrac{\$610}{1.12^2} + \dfrac{\$750}{1.12^3} - $1,040 {/eq}
  • = $435.48

Project B

Net present value:

  • {eq}= \dfrac{\$970}{1.12^1} + \dfrac{\$1,290}{1.12^2} + \dfrac{\$1,480}{1.12^3} - $2,080 {/eq}
  • = $867.89

Since the net present value for the Project B is greater than that for the Project A, the project B should be selected.


Learn more about this topic:

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How to Calculate Net Present Value: Definition, Formula & Analysis

from Financial Accounting: Help and Review

Chapter 5 / Lesson 20
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