Question

Perit Industries has $155,000 to invest. The company is trying to decide between two alternative uses of the funds. The alternatives are: Project A Project B Cost of equipment required $155,000 $0 Working capital investment required $0 $155,000 Annual cash inflows $20,000 $55,000 Salvage value of equipment in six years $9,400 $0 Life of the project 6 years 6 years 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%. Click here to view Exhibit 11B-1 and Exhibit 11B-2, to determine the appropriate discount factor(s) using tables. Required: a. Calculate net present value for each project.

b. Which investment alternative (if either) would you recommend that the company accept?

Project A

Project B

Answer 1

Solution

Perit Industries

Analysis of the two investment alternatives:

1. Calculation of net present value for each project:

Perit Industries
Net present value analysis:
Project A
Year	Cash Inflows/(outflows)	Discounting Factor at 14%	Present Value
0	($155,000)	1	($155,000)
EOY 1 – 6	$20,000	3.8888	$77,776
EOY 6	$9,400	0.4556	$4,189
Net present value			($73,035)
Project B
Year	Cash inflows/(cash outflows)	Discounting factor	Present Value
0	($155,000)	1	($155,000)
EOY 1-6	$55,000	3.8888	$213,884
Year 6	$155,000	0.4556	$70,618
Net present value			$129,502

Notes:

1. Present value factor for an ordinary annuity at end of year 6 at 14% discounting factor is 3.8888 given by the table P/A.

Project A

($25,000 x (P/A, 14%, 6) = $25,000 x 3.8888 = $77,776)

Project B

($55,000 x (P/A, 14%, 6) = $55,000 x 3.8888 = $213,884)

2. Working capital of $155,000 related to the Project B is recovered in the end of the 6^th year. Hence, the present value computation comprises present value of working capital recovered at the end of the 6^th year.

2. The recommendation is to accept Project B.

Explanation: The net present value of Project B is positive and higher at $129,502, while the net present value of Project A is negative ($73,035).