Question

Truman Industries, Inc. (TI) is considering a capital budgeting project. The appropriate discount rate for this project is 4%. The initial cost of the project will be $1,500,000. The project is expected to produce positive after tax cash flows of $440,000 per year for the next 5 years. What are the PI, IRR and regular payback for the project? Should this project be accepted? Why or why not?

Answer 1

Profitability index is calculated using the below formula:

Profitability Index= NPV + Initial investment/ Initial investment

Net present value can be calculated using a financial calculator by inputting the below:

• Press the CF button.
• CF0= -$1,500,000. Indicate the initial cash flow by a negative sign since it is a cash outflow.
• Cash flow for each year should be entered.
• Press Enter and down arrow after inputting each cash flow.
• After entering the last cash flow cash flow, press the NPV button and enter the discount rate of 4%.
• Press enter after that. Press the down arrow and CPT buttons to get the net present value.

The net present value is $458,801.83.

Profitability Index= $458,801.83 + $1,500,000/ $1,500,000

                                   = $1,958,801.83/ $1,500,000

                                   = 1.31.

Internal rate of return can be calculated using a financial calculator by inputting the below:

• Press the CF button.
• CF0= -$1,500,000. It is entered with a negative sign since it is a cash outflow.
• Cash flow for each year should be entered.
• Press Enter and down arrow after inputting each cash flow.
• After entering the last cash flow cash flow, press the IRR button and enter the interest rate to get the IRR of the project.

The IRR is 14.29%.

Payback period=full years until recovery + unrecovered cost at the start of the year/cash flow during the year

                             = 3 years + ($1,500,000 - $1,320,000)/ $440,000

                             = 3 years + $180,000/ $440,000

                             = 3 years + 0.41

                             = 3.41 years.

The project should be accepted since it generates a positive net present value.

In case of any query, kindly comment on the solution.