Question

Perit Industries has $100,000 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 $100,000 $0
Working capital investment required $0 $100,000
Annual cash inflows $21,000 $16,000
Salvage value of equipment in six years $8,000 $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%. (Ignore income taxes.)

To determine the appropriate discount factor(s) using tables, click here to view Exhibit 12B-1 (0.456) and Exhibit 12B-2 (3.889). Alternatively, if you calculate the discount factor(s) using a formula, round to three (3) decimal places before using the factor in the problem.

Required:
(a)

Calculate net present value for each project. (Negative amount should be indicated by a minus sign. Round your answer to the nearest dollar amount. Omit the "$" sign in your response.)

Net present value
Project A $ -14,683 (correct answer)
Project B $ ??

Answer 1

Concepts and reason

Capital Budgeting: The evaluation of the productivity of the fixed assets or long-life assets acquired by the company is known as evaluation of capital investments. This is also known as capital investment analysis or capital budgeting. The process of verifying and establishing the amount to be spent on property and equipment and deciding the kind of property and equipment to be purchased is referred to as capital budgeting.

Time value of money: The value of today’s money is less than the same amount at a future date. This means that the value of money increases with the time. For example: If $100 is invested at a 4% interest rate today, the value of same money would be worth $104 ($100 multiplied by 104%) after one year. This financial concept which states that money produces revenue over a period of time is called time value of money.

Net present value: The method of estimation of the present value of future cash flows using discounting technique, and deducting the capital investment from the discounted amount, is known as net present value method.

Discounting factor: The technique which computes the present value of a compounded future value by removing the compounded interest is referred to as discounting. For example, present value of $177.2 discounted at 10% for 6 time periods (six years) would be $\left( {\$ 177.2 \times 0.5645} \right)$ $100.03.

Fundamentals

Cash inflows: The benefits or cash received from the project along with the salvage value or residual value and working capital are referred to as cash inflows.

Salvage value: It is the remaining value of an asset that is estimated to be recovered after completion of the estimated useful life of the asset or at the disposal of asset. It is also called as residual value.

Present value interest factor (PVIF): The present value of a single sum is the value in today’s amounts of a cash flow to occur at a specified future date. Present value can be determined by discounting the future cash flows.

Present Value of Interest factor Annuity (PVIFA): It helps to determine the value in today’s amounts of a series of cash flow to occur at a specified future date.

Working capital requirement: The capital of business required for the day to day operations of a business concern is termed as working capital. It is the excess of current assets over current liabilities.

(a.1)

Calculate net present value of project A.

Therefore, Net present value of project A is ($14,683).

Working note:

(a.2)

Calculate net present value for project B.

Therefore, Net present value for project B is $7,824.

Working note:

Ans: Part a.1

Net present value of project A is ($14,683).

Part a.2

Net present value for project B is $7,824.