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Exercise 11-10 NPV and profitability index LO P3 Following is information on two alternative investments being considered by Jolee Company
Exercise 11-10 NPV and profitability index LO P3
Following is information on two alternative investments being considered by Jolee Company. The company requires a 8% return from its investments. (PV of $1, FV of $1, PVA of $1, and FVA of $1) (Use appropriate factor(s) from the tables provided.)
| Project A | Project B | |||||||||
| Initial investment | $ | (171,325 | ) | $ | (158,960 | ) | ||||
| Expected net cash flows in: | ||||||||||
| Year 1 | 54,000 | 27,000 | ||||||||
| Year 2 | 42,000 | 61,000 | ||||||||
| Year 3 | 82,295 | 67,000 | ||||||||
| Year 4 | 85,400 | 67,000 | ||||||||
| Year 5 | 56,000 | 32,000 | ||||||||
a. For each alternative project compute the net present value.
b. For each alternative project compute the profitability index. If the company can only select one project, which should it choose?
Expert Solution
(a)-Net Present Value of Project-A and Project-B
Net Present Value (NPV) of Project-A
|
Year |
Annual cash flows ($) |
Present Value Factor (PVF) at 8.00% |
Present Value of annual cash flows ($) [Annual cash flow x PVF] |
|
|
|
|
|
|
1 |
54,000 |
0.9259 |
49,998.60 |
|
2 |
42,000 |
0.8573 |
36,006.60 |
|
3 |
82,295 |
0.7938 |
65,325.77 |
|
4 |
85,400 |
0.7350 |
62,769.00 |
|
5 |
56,000 |
0.6806 |
38,113.60 |
|
|
|
|
|
|
TOTAL |
44,627 |
||
|
|
|
|
|
Net Present Value (NPV) = Present value of annual cash inflows – Present Value of cash outflows
= $252,213.57 - $171,325
= $80,888.57
Net Present Value (NPV) of Project-B
|
Year |
Annual cash flows ($) |
Present Value Factor (PVF) at 8.00% |
Present Value of annual cash flows ($) [Annual cash flow x PVF] |
|
|
|
|
|
|
1 |
27,000 |
0.9259 |
24,999.30 |
|
2 |
61,000 |
0.8573 |
52,295.30 |
|
3 |
67,000 |
0.7938 |
53,184.60 |
|
4 |
67,000 |
0.7350 |
49,245.00 |
|
5 |
32,000 |
0.6806 |
21,779.20 |
|
|
|
|
|
|
TOTAL |
44,627 |
||
|
|
|
|
|
Net Present Value (NPV) = Present value of annual cash inflows – Present Value of cash outflows
= $201,503.40 - $158,960
= $42,543.40
(b)-Profitability Index (PI) for Project-A and Project-B
Profitability Index for Project-A
Profitability Index = Present value of annual cash inflows / Present Value of cash outflows
= $252,213.57 / $171,325
= 1.47
Profitability Index for Project-B
Profitability Index = Present value of annual cash inflows / Present Value of cash outflows
= $201,503.40 / $158,960
= 1.27
DECISION
Company should select the PROJECT-A, since it has the higher NPV and the higher Profitability as compared to Project-B.
NOTE
The Formula for calculating the Present Value Factor is [1/(1 + r)n], Where “r” is the Discount/Interest Rate and “n” is the number of years.
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