CFA Practice Question

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CFA Practice Question

Janice is going to choose 1 of 2 investments. Both investments cost $80,000, but investment A pays $35,000 a year for four years and investment B pays $30,000 a year for five years. If her required return is 13% and each payment is made at the end of every year, which should Janice choose?
A. B because it has a higher NPV.
B. A because it pays back sooner.
C. A because its IRR exceeds 13%.
Explanation: NPV of Project A: 35000/(1+0.13)1 + 35000/(1+0.13)2 + 35000/(1+0.13)3 + 35000/(1+0.13)4 - 80000 = $24,106

NPV of Project B: 30000/(1+0.13)1 + 30000/(1+0.13)2 + 30000/(1+0.13)3 + 30000/(1+0.13)4 + 30000/(1+0.13)5 - 80000 = 25,516

User Contributed Comments 7

User Comment
EBIII I thought it must be project A - according to the equivalent annual annuity (EAA) project A has to be computed with 5years -> and it will have a higher NPV. please help!
kding I think EAA applies only when projects have significantly different lives.
MGM13 I thought A as well, since I calculated it to have a higher NPV ($153K vs. $148K).
sonict74 Unless otherwise indicated, always use NPV.
PeterW2006 I calculated that NPV(A) is higher than NPV(B) as well. Even the IRR(A) is higher than NPV(B).

Is the solution correct as it's not taking into consideration of unequal lives?
Ricci32387 Here you can infer that the answer is A just by realizing that if the IRR "exceeds" the expected return you should reject the project. Also, the pay terms do not really have an affect on an accept/reject decision
boddunah when you have mutuallly exclusive projects use NPV because it adds value to the shareholder. IRR equates present value of cash flows to NPV.IRR does not say anything about adding value to shareholders. management should take up a project that adds value to shareholder.
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