Question

Seved Ch 11 Ex 11-10 Exercise 11-10 NPV and profitability index LO P3 Following is information on two alternative investments being considered by Jolee Company. The company requires a 10% return from its investments. (EV of $1. EV of $1. PVA of $1, and EVA of $1) (Use appropriate factor(s) from the tables provided.) 20 points Project B $(154,960) Project A $(178, 325) Initial investment eBook Expected net cash flows in: Year 1 Year 2 Year 3 36,000 40,000 84,295 78,400 68,000 29,000 48,000 56,000 79,000 30,000 Hint Ask Year 4 Year 5 Pint References a. For each alternative project compute the net present value. b. For each alternative project compute the profitability index. If the company can only select one project, which should it choose? Complete this question by entering your answers in the tabs below. Required B Required A For each alternative project compute the net present value. Project A Initial Investment 178,325 Chart Values are Based on: Mc. Graw Prev 1 of 1 Next> O Type here to search х‑ O

Answer 1

REQUIREMENT A: NET PRESENT VALUE

Project A
Initial Investment		$ 178,325.00
Chart Values are Based on:
i=	10	%
Year	Cash Inflow	×	PV Factor	=	Present Value
1	$           36,000.00	×	0.9091	=	$           32,727.60
2	$           40,000.00	×	0.8264	=	$           33,056.00
3	$           84,295.00	×	0.7513	=	$           63,330.83
4	$           78,400.00	×	0.6830	=	$           53,547.20
5	$           68,000.00	×	0.6209	=	$           42,221.20
Present Value of Cash Inflows					$ 224,882.83
Present Value of Cash Inflows (a)					$ 224,882.83
Initial Investment (b)					$ 178,325.00
Net Present Value (a) - (b)					$           46,557.83
Project B
Initial Investment		$ 154,960.00
Chart Values are Based on:
i=	10	%
Year	Cash Inflow	×	PV Factor	=	Present Value
1	$           29,000.00	×	0.9091	=	$           26,363.90
2	$           48,000.00	×	0.8264	=	$           39,667.20
3	$           56,000.00	×	0.7513	=	$           42,072.80
4	$           79,000.00	×	0.6830	=	$           53,957.00
5	$           30,000.00	×	0.6209	=	$           18,627.00
Present Value of Cash Inflows					$ 180,687.90
Present Value of Cash Inflows (a)					$ 180,687.90
Initial Investment (b)					$ 154,960.00
Net Present Value (a) - (b)					$           25,727.90

REQUIREMENT B: PROFITABILITY INDEX AND DECISION

Profitability Index
	Choose Numerator:	/	Choose Denominator:	=	Profitability Index
	PV of Future Cash Flows	/	Initial Investment	=	Profitability Index
Project A	$ 224,882.83	/	$ 178,325.00	=	1.26
Project B	$ 180,687.90	/	$ 154,960.00	=	1.17
If the company can only select one project, which should it choose?				Project A

• Project A has a higher NPV and profitability index and hence it should be selected.

PV Factor:

1 PV factor = (1 + r)n Where, • r = rate of return • n = number of years (or periods)

• To illustrate, PV factor for Year 5 at 10% = 1 ÷ (1+0.10)⁵ = 0.6209
• Present value of cash flow at a future time: Present value = Future value × PV factor
  • To illustrate, present value of cash flow of project B in Year 5 = $30,000 × 0.6209 = $18,627

NPV

• Net present value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows over the life of an investment project.
• NPV is used to evaluate investment projects in capital budgeting.
• A project with a positive NPV is accepted. A positive NPV indicates that the project will result in net cash inflows in today's dollars.
• A project with a negative NPV is rejected. A negative NPV indicates that the project will result in net cash outflows in today's dollars.
• The cash flows are discounted at a required rate of return. It may be a weighted average cost of capital, cost of debt, etc.

Profitability Index

• The profitability index is a ratio that expresses the relationship between the costs and benefits of a project.
• Profitability index = PV of future cash flows ÷ Initial investment
• Profitability index greater than 1: Project should be accepted (it indicates the present value of anticipated future cash inflows are more than the present value of cash outflows)
• Profitability index less than 1: Project should be rejected. (it indicates the present value of anticipated future cash inflows are less than the present value of cash outflows)
• Profitability index equal to 1: Project is indifferent. (it indicates the present value of anticipated future cash inflows equals the present value of cash outflows)
• In case of mutually exclusive projects, the project with the highest profitability index is accepted.