Question

NPV: Mutually exclusive projects Hook Industries is considering the replacement of
one of its old drill presses. Three alternative replacement presses are under consideration.
The relevant cash flows associated with each are shown in the following table.
The firm’s cost of capital is 15%.
LG 3
LG 2 LG 3
LG 3
Press A Press B Press C
Initial investment (CF0) $85,000 $60,000 $130,000
Year (t) Cash inflows (CFt)
1 $18,000 $12,000 $50,000
2 18,000 14,000 30,000
3 18,000 16,000 20,000
4 18,000 18,000 20,000
5 18,000 20,000 20,000
6 18,000 25,000 30,000
7 18,000 — 40,000
8 18,000 — 50,000
a. Calculate the net present value (NPV) of each press.
b. Using NPV, evaluate the acceptability of each press.
c. Rank the presses from best to worst using NPV.
d. Calculate the profitability index (PI) for each press.
e. Rank the presses from best to worst using PI.

Answer 1

Concepts and reason

Cash flow: Cash flow refers to the movement of cash. It consists of two categories, such as cash inflow and cash outflow. Cash inflow represents revenue or cash earned. Cash outflow represents cash spent.

Net present value: The difference between the inflow of cash and outflow of cash during a period is known as the net present value. If the net present value is positive, the investment or proposal can be accepted.

Fundamentals

Present value: The present value is the value known at the time for an expected sum of money to be received in the future. It can be expected for a specified rate of return. It is the discounted value of money. It may be less than or equal to the future value.

Profitability index: Profitability index is an appraisal technique which determines whether the proposal can be accepted or rejected. It estimates the track between the cost incurred and profit to be achieved. The formula for calculating profitability index is as follows:

a)

Calculate the net present value of Press A:

Therefore, the net present value of Press A is ($4,234).

Calculate the net present value of Press B:

Therefore, the net present value of Press B is $2,588.

Calculate the net present value of Press C:

Therefore, the net present value of Press C is $15,070.

Working notes:

Calculation for Press A is given below:

Calculation for Press B is given below:

Calculation for Press C is given below:

b)

Determine the acceptability of each press:

Therefore, projects B and C will be accepted and A will be rejected.

c)

Determine the rank of press:

Therefore, based on the net present value, Press C is 1^st, Press B is 2^nd and Press A is 3^rd.

d)

Calculate the profitability index for each press:

Therefore, the profitability index for Press A is 0.95, press B is 1.04 and Press C is 1.12.

e)

Determine the rank of the presses using the profitability index:

Therefore, using the profitability index, Press C is 1^st, Press B is 2nd and Press A is 3^rd.

Ans: Part a

The net present value of Press A is ($4,234), press B is $2,588, and press C is $15,070.

Part b

Projects B and C will be accepted and A will be rejected.

Part c

Based on the net present value, Press C is 1^st, Press B is 2^nd and Press A is 3^rd.

Part d

The profitability index for Press A is 0.95, Press B is 1.04 and Press C is 1.12.

Part e

Using the profitability index, Press C is 1^st, Press B is 2nd and Press A is 3^rd.