King Racing Company (KRC) is considering which of two mutually exclusive engine development projects to pursue. King's RPX design has an expected life of 4 years and projected cash inflows are $3.6 million at the end of each of the first two years and $1.8 million in each of the next two years. King's RPB design is more flexible and has an eight-year life. The projected end-of-year flows from the RPB design are $2.4 million in each of the first two years and $2.0 million in each of the next six years. Both projects require an initial investment of $5.4 million, and King's cost of capital is 12 percent. Frequent changes in racing rules and engine technology make engine development risky, but King feels that the basic designs can be refined and modified. Thus, King often assumes that continuous replacements can be made as a project's life ends. What is the net present value (on an eight-year extended basis) of the project with the most value to the company?

Question

Quizplus · Accepted Answer

To find the best choice, we need to calculate the NPV of each project and compare them.

For RPX: 
Year 1: $3.6 million / (1+0.12)^1 = $3.214 million 
Year 2: $3.6 million / (1+0.12)^2 = $2.869 million 
Year 3: $1.8 million / (1+0.12)^3 = $1.064 million 
Year 4: $1.8 million / (1+0.12)^4 = $0.950 million

NPV of RPX = -$5.4 million + $3.214 million + $2.869 million + $1.064 million + $0.950 million = $2.649 million

For RPB: 
Year 1: $2.4 million / (1+0.12)^1 = $2.143 million 
Year 2: $2.4 million / (1+0.12)^2 = $1.917 million 
Year 3-8: $2.0 million / (1+0.12)^3 - (1+0.12)^8 = $8.868 million

NPV of RPB = -$5.4 million + $2.143 million + $1.917 million + $8.868 million = $7.527 million

Therefore, RPB has a higher NPV and is the best choice for the company. The answer is D.

King Racing Company (KRC) Is Considering Which of Two Mutually