NASAA Series 65, Uniform Investment Adviser Law ExaminationEconomic Factors and Business InformationHard
A company is considering two mutually exclusive projects. Project A has a Net Present Value (NPV) of $50,000, and Project B has an NPV of $70,000. Both projects require the same initial investment. Based solely on the NPV rule, which project should the company choose?
- AProject B, because it has a higher positive NPV.
- BIt depends on the company's cost of capital.
- CProject A, because it has a positive NPV.
- DNeither, as both have positive NPVs and are mutually exclusive.
Show answer & explanationAnswer & explanation
Correct answer: A. Project B, because it has a higher positive NPV.
When evaluating mutually exclusive projects using the Net Present Value (NPV) rule, the project with the highest positive NPV should be chosen, as it is expected to add the most value to the company. In this case, Project B has a higher NPV of $70,000 compared to Project A's $50,000.
Why the other options are wrong
- B. The NPV calculation already incorporates the cost of capital as the discount rate.
- C. While Project A is acceptable, Project B is superior because it adds more value.
- D. Mutually exclusive means you choose only one; the rule is to pick the best one, not reject both.
Net Present Value (NPV) Rule for Mutually Exclusive Projects
When evaluating multiple projects where only one can be chosen (mutually exclusive), select the project with the highest positive Net Present Value.
- NPV measures the present value of expected cash inflows minus the present value of expected cash outflows.
- A positive NPV indicates the project is expected to add value.
- For mutually exclusive projects, the highest positive NPV maximizes shareholder wealth.
Memory trick: How to pick the best investment path for profit.