IMANET Exam CMA Topic 3 Question 88 Discussion

The cash flows of Plan A are discounted at 12%, the company's cost of capital for average risk projects. Plan B is evaluated with a lower cost of capital that reflects a greater risk of the cash outflow of the project. Thus, the cash flows of Plan B are discounted at 10% (12% --- 2%). the company's adjusted cost of capital for high risk projects. The net present value of each plan is the initial cost plus the present value of an annuity for 10 years at the appropriate rate multiplied times the annual operating cost.

The present value factors are found in the tools section of CMA Test Prep.

Plan A NPV = $10,000,000 + ($1,000,000 x 5.650)

Plan A NPV = $15,650,000

Plan B NPV = $5,000,000 + ($2,000,000 x 6.145)

Plan B NPV = $17,290,000

Plan A has a lower NPV and thus is the better project.