Question

McKnight Company is considering two different, mutually exclusive capital expenditure proposals. Project A will cost $459,000, has an expected useful life of 11 years, a salvage value of zero, and is expected to increase net annual cash flows by $74,600. Project B will cost $274,000, has an expected useful life of 11 years, a salvage value of zero, and is expected to increase net annual cash flows by $46,200. A discount rate of 9% is appropriate for both projects

Net present value - Project A
Profitability index - Project A
Net present value - Project B
Profitability index - Project B

Which project should be accepted based on Net Present Value?

Which project should be accepted based on profitability index?

Answer 1

(1) for project A,

(a)

net present value = present value of annual net cash flows - initial investment

= {$74600 x PVAF(9%,11)} - $459000

= ($74600 x 6.80519) - $459000

= $507667.174 - $459000

= $48667.17

where,

PVAF(9%,11) = 6.80519

(b)

profitability index = present value of annual net cash flows/initial investment

=  $507,667.174/$459000

= 1.11

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(1) for project B

(a)

net present value = present value of annual net cash flows - initial investment

= {$46200 x PVAF(9%,11)} - $274000

= ($46200 x 6.80519) - $274000

= $314399.778 - $274000

= $40,399.78

where,

PVAF(9%,11) = 6.80519

(b)

profitability index = present value of annual net cash flows/initial investment

=  $314399.778/$274000

= 1.15

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CONCLUSION:

project A should be accepted based on Net Present Value.

project B should be accepted based on profitability index