Question

Question 6:

XYZ Construction is considering two projects to develop. The expected cash inflows are

as follows :

                 Project M      Project N

Year 1        10,000        25,000

Year 2        15,000         25,000

Year 3         20,000        25,000

Year 4         25,000        25,000

Year 5         30,000         25,000

Each Project requires an investment of $100,000. A rate of 10% has been selected for the NPV

Analysis.                                                                            

Required:

a) Calculate the NPV and the Profitability Index and suggest which project should be

recommended based on each method.

b) Explain what the key decisions are a Finance Manager has to take in an

Organization with suitable examples.

Answer 1

Net Present Value (NPV) for PROJECT-M

Year	Annual cash flows ($)	Present Value factor at 10.00%	Present Value of Annual cash flows ($)
1	10,000	0.909091	9,090.91
2	15,000	0.826446	12,396.69
3	20,000	0.751315	15,026.30
4	25,000	0.683013	17,075.34
5	30,000	0.620921	18,627.64
TOTAL			72,216.88

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

= $72,216.88 - $100,000

= -$27,783.12 (Negative NPV)

Net Present Value (NPV) for PROJECT-N

Year	Annual cash flows ($)	Present Value factor at 10.00%	Present Value of Annual cash flows ($)
1	25,000	0.909091	22,727.27
2	25,000	0.826446	20,661.16
3	25,000	0.751315	18,782.87
4	25,000	0.683013	17,075.34
5	25,000	0.620921	15,523.03
TOTAL			94,769.67

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

= $94,769.67 - $100,000

= -$5,230.33 (Negative NPV)

Profitability Index (PI) for PROJECT-M

Profitability Index (PI) = Present Value of annual cash inflows / Initial Investment

= $72,216.88 / $100,000

= 0.72

Profitability Index (PI) for PROJECT-N

Profitability Index (PI) = Present Value of annual cash inflows / Initial Investment

= $94,769.67 / $100,000

= 0.95

NOTE

The formula for calculating the Present Value Inflow Factor (PVIF) is [1 / (1 + r)ⁿ], where “r” is the Discount Rate/Cost of capital and “n” is the number of years.