Question

Project K requires an initial investment of $450,000, is expected to last for 7 years, and is expected to produce after-tax net cash flows of $92,000 per year. Project L requires $3000 initial investment and produces a net cash flow of $800 per year. The discount rate for both projects is 8%.

a) What is the NPV of each project?

b) What is the Profitability Index of each project?

c) Which one will you choose?

Answer 1

Part A :NPV of each Project

Project K

PV of Cashflows for 7years at 8% = Annual cash flow x 1/((1+r)^n)

= 92,000 x 1/(1+8%)^7)

= 92,000 x 5.21

= $ 4,79,320

NPV of Project K = PV of Cashflows - Initial investments

= $ 4,79,320 - $ 4,50,000

= $ 29,320

Project L

PV of cashflows for 7 years at 8% = Annual cash flow x 1/((1+r)^n)

= 800 x 1/(1+8%)^7)

= 800 x 5.21

= $ 4,168

NPV of Project L = PVof cashflows - Initial investment

= $ 4,168 - $ 3,000

= $ 1,168

Part B : Profitability index

Project K = PV of Inflows / initial investment = $ 4,79,320 / $ 4,50,000 = 1.065

Project L = PV of Inflows / initial investment = $ 4,168 / $ 3,000 = 1.389

Part C: Choosing the project

As per NPV method, Project K should be selected but as per Profitability Index, Project L should be selected. In case of conflict between NPV and Profitability Index, projects should always be selected based on NPV method because it maximizes the shareholders wealth. Accordingly, Project K should be selected.