Problem 3.10 Net Present Value. Assume that your firm wants to choose between two project options: Project A: $500,000 invested today will yield an expected income stream of $150,000 per year for 5 years, starting in Year 1. Project B: an initial investment of $400,000 is expected to produce this revenue stream: Year 1 = 0, Year 2 = $50,000, Year 3 = $200,000, Year 4 = $300,000, and Year 5 = $200,000. Assume that a required rate of return for your company is 10% and that inflation is expected to remain steady at 3% for the life of the project. Which is the better investment? Why?

Project B is a better investment

Explanation:

Given:

Project A's initial investment is $500,000

Expected cash inflow starting from year 1 for 5 years is $150,000

Required rate of return is 10% and inflation is 3%. So required rate of return is 13%

NPV of project A = - 500,000 + Present value of annuity of $150,000, 5 years at 13%

Present value of annuity factor of $1, 13%, 5 periods = 3.5172

NPV of project A = - 500,000 + (150,000 * 3.5172)

= $27,580

Poject B's initial investment = $400,000

Use present value factor of $1, 13% to compute present value of cash inflows:

Year 1 = 0

Year 2 = 50,000 * 0.7831 = 39,155

Year 3 = 200,000 * 0.6931 = 138,620

Year 4 = 300,000 * 0.6133 = 183,990

Year 5 = 200,00 * 0.5428 = 108,560

NPV of project B = - 400,000 + (39,155 + 138,620 + 183,990 + 108,560)

= $70,325

Since project B's NPV is higher than project A, project B is a better investment.