Question

Bill Zimmerman is evaluating two new business opportunities. Each of the opportunities shown below has a ten-year life. Bill uses a 12% discount rate.

		Option 1		Option 2
Equipment purchase and installation		$70,200		$82,120
Annual cash flow		$28,600		$31,070
Equipment overhaul in year 3		$4,810		-
Equipment overhaul in year 5		-		$6,250

Calculate the net present value of the two opportunities. (Round present value factor calculations to 4 decimal places, e.g. 1.2514 and the final answers to 0 decimal places, e.g. 59,991.)

Calculate the profitability index of the two opportunities. (Round answers to 2 decimal places, e.g. 15.25.)

Which option should Bill choose?

Answer 1

Net Present Value of OPTION-1

Year	Annual cash flows ($)	Present Value Factor (PVF) at 12.00%	Present Value of annual cash flows ($) [Annual cash flow x PVF]
1	28,600	0.8929	25,537
2	28,600	0.7972	22,800
3	23,790 [28,600 – 4,810]	0.7118	16,934
4	28,600	0.6355	18,175
5	28,600	0.5674	16,228
6	28,600	0.5066	14,489
7	28,600	0.4523	12,936
8	28,600	0.4038	11,549
9	28,600	0.3605	10,310
10	28,600	0.3219	9,206
TOTAL		158,163

Net Present Value (NPV) = Present Value of annual cash inflows – Initial Investment

= $158,163 - $70,200

= $87,963

Net Present Value of OPTION-2

Year	Annual cash flows ($)	Present Value Factor (PVF) at 12.00%	Present Value of annual cash flows ($) [Annual cash flow x PVF]
1	31,070	0.8929	27,742
2	31,070	0.7972	24,769
3	31,070	0.7118	22,116
4	31,070	0.6355	19,745
5	24,820 [31,070 – 6,250]	0.5674	14,083
6	31,070	0.5066	15,740
7	31,070	0.4523	14,053
8	31,070	0.4038	12,546
9	31,070	0.3605	11,201
10	31,070	0.3219	10,001
TOTAL		171,996

Net Present Value (NPV) = Present Value of annual cash inflows – Initial Investment

= $171,996 - $82,120

= $89,876

Profitability Index for OPTION-1

Profitability Index for OPTION-1 = Present Value of annual cash inflows / Initial Investment

= $158,163 / $70,200

= 2.25

Profitability Index for OPTION-2

Profitability Index for OPTION-2 = Present Value of annual cash inflows / Initial Investment

= $171,996 / $82,120

= 2.09

DECISION

The OPTION-2 should be selected, since it has the higher Net Present Value

NOTE    

The Formula for calculating the Present Value Factor is [1/(1 + r)n], Where “r” is the Discount/Interest Rate and “n” is the number of years.