Question

Problem 2 Mobil Company has hired a consultant to propose a way to increase the company's revenues. The consultant has evaluated two mutually exclusive projects with the following information provided for each project: Capital investment Annual cash flows Estimated useful life Project Turtle $1,105,000 180,000 10 years Project Snake $625,000 105,000 10 years Mobil Company uses a discount rate of 9% to evaluate both projects. Instructions (a) Calculate the net present value of both projects. (b) Calculate the profitability index for each project. (c) Which project should Mobil accept?

Answer 1

The Net Present Value (NPV) of Project Turtle

Year	Annual cash flows ($)	Present Value Factor (PVF) at 9.00%	Present Value of annual cash flows ($) [Annual cash flow x PVF]
1	1,80,000	0.9174312	1,65,137.61
2	1,80,000	0.8416800	1,51,502.40
3	1,80,000	0.7721835	1,38,993.03
4	1,80,000	0.7084252	1,27,516.54
5	1,80,000	0.6499314	1,16,987.65
6	1,80,000	0.5962673	1,07,328.12
7	1,80,000	0.5470342	98,466.16
8	1,80,000	0.5018663	90,335.93
9	1,80,000	0.4604278	82,877.00
10	1,80,000	0.4224108	76,033.95
TOTAL		11,55,178.39

Net Present Value (NPV) = Present Value of annual cash inflows – Initial Investment

= $11,55,178.39 - $11,05,000

= $50,178.39

The Net Present Value (NPV) of Project Snake

Year	Annual cash flows ($)	Present Value Factor (PVF) at 9.00%	Present Value of annual cash flows ($) [Annual cash flow x PVF]
1	1,05,000	0.9174312	96,330.28
2	1,05,000	0.8416800	88,376.40
3	1,05,000	0.7721835	81,079.27
4	1,05,000	0.7084252	74,384.65
5	1,05,000	0.6499314	68,242.80
6	1,05,000	0.5962673	62,608.07
7	1,05,000	0.5470342	57,438.60
8	1,05,000	0.5018663	52,695.96
9	1,05,000	0.4604278	48,344.92
10	1,05,000	0.4224108	44,353.13
TOTAL		6,73,854.06

Net Present Value (NPV) = Present Value of annual cash inflows – Initial Investment

= $6,73,854.06 - $625,000

= $ 48,854.06

Profitability Index (PI) for Project Turtle

Profitability Index (PI) = Present Value of annual cash inflows / Initial Investment

= $11,55,178.39 / $11,05,000

= 1.05

Profitability Index (PI) for Project Snake

Profitability Index (PI) = Present Value of annual cash inflows / Initial Investment

= $673,854.06 / $625,000

= 1.08

DECISION

-As per the Net Present Value method, the Project Turtle should be accepted, since it has the highest NPV of $50,178.39.

-As per the PI method, the Project Snake should be accepted, since it has the higher Profitability Index of 1.08.

NOTE

The formula for calculating the Present Value Inflow Factor (PVIF) is [1 / (1 + r)n], where “r” is the Discount Rate/Cost of capital and “n” is the number of years.