Question

1. VDSL Company has two mutually exclusive projects. Below is a table representing the initial investment and cash flows for these projects over four (4) years.

	Project A	Project B
Year	Cash Flow	Cash Flow
	$	$
0	-750,000	-750,000
1	250,000	200,000
2	350,000	400,000
3	250,000	100,000
4	200,000	175,000

a. If the company’s required rate of return is 8%, calculate the Profitability Index of each project and determine which project is the best investment.

b.   If the company wishes to recover the investment in 2.5 years, calculate the payback period of each project and determine which project is the best investment.                    

Answer 1

a.			Project A	Project B
	Profitability Index	1.17	0.98
	Project A is the best investment as it has profitability index of more than 1.
Working:
	# 1: Calculation of present value of cash inflow
			Project A			Project B
	Year	Discount factor	Cash inflow	Discounted cash inflow	Cash inflow	Discounted cash inflow
	a	b=1.08^-a	c	d=c*b		e	f=e*b
	1	0.925926	$   2,50,000.00	$   2,31,481.48		$    2,00,000.00	$   1,85,185.19
	2	0.857339	$   3,50,000.00	$   3,00,068.59		$    4,00,000.00	$   3,42,935.53
	3	0.793832	$   2,50,000.00	$   1,98,458.06		$    1,00,000.00	$       79,383.22
	4	0.73503	$   2,00,000.00	$   1,47,005.97		$    1,75,000.00	$   1,28,630.22
	Total			$   8,77,014.10			$   7,36,134.16
	# 2:Calculation of profitability index
	Profitability index	=	Present value of cash inflow	/	Investment
	So,
	Profitability index of:
	Project A	=	$   8,77,014.10	/	$ 7,50,000.00	=	1.17
	Project B	=	$   7,36,134.16	/	$ 7,50,000.00	=	0.98
b.			Project A	Project B
	Payback Period	2.60 Years	3.29 Years
	Although both project failed to recover the investment in 2.5 years, Project A has earlier recovery than Project B.
	So, Project A is best investment.
Working:
			Project A			Project B
		Year	Cash flow	Cumulative cash flow	Cash flow	Cumulative cash flow
		0	$ -7,50,000.00	$ -7,50,000.00		$ -7,50,000.00	$ -7,50,000.00
		1	$   2,50,000.00	$ -5,00,000.00		$    2,00,000.00	$ -5,50,000.00
		2	$   3,50,000.00	$ -1,50,000.00		$    4,00,000.00	$ -1,50,000.00
		3	$   2,50,000.00	$   1,00,000.00		$    1,00,000.00	$     -50,000.00
		4	$   2,00,000.00	$   3,00,000.00		$    1,75,000.00	$   1,25,000.00
	Payaback period of:
	Project A	=	2+(150000/250000)	=	2.60
	Project B	=	3+(50000/175000)	=	3.29