Question

P10–10 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

Solution-

NPV OF Press A : as it has constant $18000 cash inflow, so PVIFA_{(15, 8)} applies,

So, NPV OF Press A = $18000 * 4.487 - $85000 = (-) $4234

NPV OF Press B and C:

year	cash flow Press B	discount value 15%	present value PressB	cash flow Press C	present value Press C
0	-60000	1		-130000	-130000
1	12000	0.870	10440	50000	43500
2	14000	0.756	10584	30000	22680
3	16000	0.658	10528	20000	13160
4	18000	0.572	10296	20000	11440
5	20000	0.497	9940	20000	9940
6	25000	0.432	10800	30000	12960
7		0.376		40000	15040
8		0.327		50000	16350
		NPV	+$2588	NPV	+$15070

a. NPV OF A = (-) $4234 B=+$2588 C=+$15070

b. Press C will be accepted as having higher NPV of $15070 in all the presses.

c. Rank 1 - Press C Rank 2 - Press B Rank 3 - Press A as per NPV.

d. profitability index (PI) of Press A = pv of cash flow / initial investment = 80766/85000 = 0.95

Press B = 62588 / 60000 = 1.04

Press C = 145070 / 130000 = 1.11

e. Rank 1 - Press C Rank 2 - Press B Rank 3 - Press A as per PI.