Question

EXERCISE 13–7 Net Present Value Analysis of Two Alternatives Perit Industries has $100,000 to invest. The company is trying to decide between two alternative uses of the funds. The alternatives are: The working capital needed for project B will be released at the end of six years for investment elsewhere. Perit Industries' discount rate is 14%. Project A Project B Cost of equipment required ............. Working capital investment required ....... Annual cash inflows... Salvage value of equipment in six years ........ Life of the project .... $100,000 $0 $21,000 $8,000 6 years $0 $100,000 $16,000 20,000 6 years Required: Which investment alternative (if either) would you recommend that the company accept? Show all computations using the net present value format. Prepare separate computations for each project Note: This Question should be answered by annual cash net flow, should be muliplied by PVF for annuity.

NOTE: Annual cash net flow should be multiplied by PVF for annuity

Answer 1

Answer -

Step - (1) - Information Given -

Perit Industries has $100000 to invest.

Perit Industries' discount rate is 14%.

	Project A	Project B
Cost of equipment required	$100000	$0
Working capital investment required	$0	$100000
Annual cash inflows	$21000	$16000
Salvage value of equipment in six years	$8000	$0
Life of the project	6 years	6 years

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Step - (2) - Calculation of Net Present Value of Project A -

Year (s)	Particulars	Calculation	Present Value ($)
0	Cost of the equipment	Given in question	(100000)
1-6	Annual cash inflows	= Annual cash inflows * PVAF(6 years, 14%) = $21000 * 3.88867 = $81662	81662
6	Salvage value of the equipment	= Salvage value * PVIF(6 years, 14%) = $8000 * 0.45559 = $3645	3645
Net Present Value of Project A		-$100000 + $81662 + $3645	(14693)

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Step - (2) - Calculation of Net Present Value of Project B -

Year (s)	Particulars	Calculation	Present Value ($)
0	Working capital investment	Given in question	(100000)
1-6	Annual cash inflows	= Annual cash inflows * PVAF(6 years, 14%) = $16000 * 3.88867 = $62219	62219
6	Working capital released	= Salvage value * PVIF(6 years, 14%) = $100000 * 0.45559 = $45559	45559
Net Present Value of Project B		-$100000 + $62219 + $45559	7778

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Step - (3) - Recommendation -

Company should accept Project B, because Project B has a positive net present value whereas Project A has a negative net present value.