Question

Steve's Stoves Company, which desires a minimum rate of return on its investment projects of 15%, has two proposals under consideration. Their costs and expected cash flows are: A B $132,000 $96,000 Initial investment Expected after-tax cash flows: Year 1 Year 2 Year 3 Year 4 $40,000 $32,000 $48,000 $24,000 $52,000 $56,000 $40,000 $32,000 In addition, proposal B has an expected cash salvage value at the end of four years of $8,000. The present value of $1 due in 1, 2, 3, and 4 years at 15% is .86957, .75614,.65752, and .57175, respectively. Using the profitability index method, determine which project, if either, should be accepted by the company.

Answer 1

Project A should be accepted

Working

	Project A	Project B
Profitability index	1.09	1.04

Project A has higher profitability index so project A should be accepted.

Project A
Year	Annual Cash Flow	NPV Factor at 15% Discount rate	Discounted Cash Flow
1	$ 40,000	0.86957	$ 34,783
2	$ 32,000	0.75614	$ 24,196
3	$ 48,000	0.65752	$ 31,561
4	$ 24,000	0.57175	$ 13,722
Present value of Cash Inflows			$ 104,262
Less: Initial Investment			$ 96,000
Net Present value			$ 8,262
Profitability index			1.09

..

Project B
Year	Annual Cash Flow	NPV Factor at 10% Discount rate	Discounted Cash Flow
1	$ 52,000	0.86957	$ 45,218
2	$ 56,000	0.75614	$ 42,344
3	$ 40,000	0.65752	$ 26,301
4	$ 40,000	0.57175	$ 22,870
Present value of Cash Inflows			$ 136,732
Less: Initial Investment			$ 132,000
Net Present value			$ 4,732
Profitability index			1.04