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29 June, 15:29

Leslie is charged with determining which small projects should be funded. Along with this assignment, she has been granted the use of $15,000 for a maximum of two years on a discounted basis. She is considering three projects. Project A costs $7,500 and has cash flows of $4,000 a year for Years 1 to 3. Project B costs $8,000 and has cash flows of $3,000, $4,000, and $3,000 for Years 1 to 3, respectively. Project C costs $2,000 and has a cash inflow of $2,500 in Year 2. What decisions should she make regarding these projects if she assigns them a mandatory discount rate of 8.5 percent? Explain why.

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  1. 29 June, 15:55
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    The answer is: Leslie should fund projects A and C

    Explanation:

    In order to determine if a project should be accepted, the first thing Leslie has to do is determine the projects' Net Present Value (NPV). If the NPV is 0 or more, then the projects could be funded.

    The formula to calculate NPV is:

    NPV = ∑{p / (1+r) t} - C

    p = net cash flows from the period r = discount rate (8.5% in this case) t = number of periods c = capital invested

    Project A:

    p = $4000; $4000; $4000

    r = 8.5%

    t = 3

    c = $7,500

    The NPV for Project A is $2,716.09

    Project B:

    p = $3000; $4000; $3000

    r = 8.5%

    t = 3

    c = $8,000

    The NPV for Project B is $511.52

    Project C:

    p = $0; $2,500

    r = 8.5%

    t = 2

    c = $2,000

    The NPV for Project C is $123.64

    Once you calculate the NPVs from projects A, B and C you must determine how to distribute the $15,000 available. All three projects have positive NPVs, so they are profitable. But you can't fund projects A and B since their combined costs ($7,500 + $8,000 = $15,500) exceeds $15,000. Leslie should invest in project A since its NPV is higher ($2,716.09 ˃ $511.52). She should also fund project C since its NPV is positive ($123.64) and the capital needed is smaller (only $2,000).
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