Question

The treasurer of Amaro Canned Fruits, Inc., has projected the cash flows of projects A, B, and C as follows:

Year	Project A			Project B			Project C
0	−	$	200,000	−	$	365,000	−	$	200,000
1			129,000			226,000			139,000
2			129,000			226,000			109,000

  

Suppose the relevant discount rate is 8 percent per year.
  
a. Compute the profitability index for each of the three projects. (Do not round intermediate calculations. Round your answers to 2 decimal places, e.g., 32.16.)

  

	Profitability index
Project A
Project B
Project C

  

b. Compute the NPV for each of the three projects. (Do not round intermediate calculations. Round your answers to 2 decimal places, e.g., 32.16.)

  

	NPV
Project A	$
Project B	$
Project C	$

  

c. Suppose these three projects are independent. Which project(s) should Amaro accept based on the profitability index rule?
  

	Project A
	Project B
	Project C
	Project A, Project B, Project C
	Project A, Project B
	Project A, Project C
	Project B, Project C

  
d. Suppose these three projects are mutually exclusive. Which project(s) should Amaro accept based on the profitability index rule?
  

	Project B
	Project A
	Project C
	Project A, Project B
	Project A, Project B, Project C
	Project A, Project C
	Project B, Project C

  
e. Suppose Amaro’s budget for these projects is $565,000. The projects are not divisible. Which project(s) should Amaro accept?
  

	Project A
	Project B
	Project C
	Project A, Project B, Project C
	Project B, Project C
	Project B, Project A
	Project A, Project C

Answer 1

a. Profitability index is computed by using the below formula:

= Present value of future cash flows / Initial investment

PI of project A

= ( $ 129,000 / 1.08¹ + $ 129,000 / 1.08² ) / $ 200,000

= 1.15 Approximately

PI of project B

= ( $ 226,000 / 1.08¹ + $ 226,000 / 1.08² ) / $ 365,000

= 1.10 Approximately  

PI of project C

= ( $ 139,000 / 1.08¹ + $ 109,000 / 1.08² ) / $ 200,000

= 1.11 Approximately  

b. The NPV of the projects is computed as shown below:

NPV of project A is shown below:

= - $ 200,000 + $ 129,000 / 1.08¹ + $ 129,000 / 1.08²

= $ 30,041.15 Approximately

NPV of project B is shown below:

= - $ 365,000 + $ 226,000 / 1.08¹ + $ 226,000 / 1.08²

= $ 38,017.83 Approximately

NPV of project C is shown below:

= - $ 200,000 + $ 139,000 / 1.08¹ + $ 109,000 / 1.08²

= $ 22,153.64 Approximately

c. Since all of the projects PI is greater than 1, hence all the project shall be accepted. So the correct answer is option of Project A, Project B, Project C.

d. Since the PI of project A is the highest among all the three projects, hence project A shall be accepted. So the correct answer is option of Project A.

e. Project A and B shall be executed if the budget is $ 565,000, since they will result in the highest NPV of

= $ 30,041.15  + $ 38,017.83

= $ 68,058.98

So the correct answer is option of Project B, Project A.

Feel free to ask in case of any query relating to this question