You are going to choose between two investments. Both cost $80,000, but investment A pays $35,000 a year for four years while investment B pays $30,000 a year for ﬁve years. If your
Required return is 13%, which should you choose?
A) A, because the pays back sooner.
B) A, because the IRR exceeds 13%.
C) A, because the project has a higher IRR.
D) B, because the IRR exceeds 13%.
E) B, because it has a higher NPV.

Question

Quizplus · Accepted Answer

The best choice is investment B because it has a higher NPV. To calculate the NPV for each investment, we need to discount the cash flows using the required return of 13%.

For investment A: 
Year 1: 35,000/(1+0.13)^1 = 30,973 
Year 2: 35,000/(1+0.13)^2 = 27,406 
Year 3: 35,000/(1+0.13)^3 = 24,181 
Year 4: 35,000/(1+0.13)^4 = 21,250 
NPV = -80,000 + 30,973 + 27,406 + 24,181 + 21,250 = 23,810

For investment B: 
Year 1: 30,000/(1+0.13)^1 = 26,549 
Year 2: 30,000/(1+0.13)^2 = 23,484 
Year 3: 30,000/(1+0.13)^3 = 20,781 
Year 4: 30,000/(1+0.13)^4 = 18,412 
Year 5: 30,000/(1+0.13)^5 = 16,347 
NPV = -80,000 + 26,549 + 23,484 + 20,781 + 18,412 + 16,347 = 31,573

Investment B has a higher NPV of $31,573 compared to investment A's NPV of $23,810, so investment B is the better choice.

You Are Going to Choose Between Two Investments