Question

Bunnings Ltd is considering to invest in one of the two following projects to buy a new equipment. Each equipment will last 5 years and have no salvage value at the end. The company’s required rate of return for all investment projects is 8%. The cash flows of the projects are provided below.

	Equipment 1	Equipment 2
Cost	$186,000	$195,000
Future Cash Flows Year 1 Year 2 Year 3 Year 4 Year 5	86 000 93 000 83 000 75 000 55 000	97 000 84 000 86 000 75 000 63 000

Required:

1. Identify which option of equipment should the company accept based on Profitability Index?

2. Identify which option of equipment should the company accept based on discounted pay back method if the payback criterion is maximum 2 years?

Answer 1

a.

Equipment 1
Year	Cash Flows	Discounting factor 8%	Discounted Cash Flow	Cumulative
0	(186,000)	1	(186,000)	(186,000)
1	86,000	0.9259	79,630	(106,370)
2	93,000	0.8573	79,733	(26,638)
3	83,000	0.7938	65,888	39,250
4	75,000	0.7350	55,127	94,377
5	55,000	0.6806	37,432	131,810

Profitability Index = Present Value of Future Cash Flows / Initial Investment

Therefore PI for Equipment 1

= 317810 / 186000

= 1.71

Equipment 2
Year	Cash Flows	Discounting factor 8%	Discounted Cash Flow	Cumulative
0	(195,000)	1	(195,000)	(195,000)
1	97,000	0.9259	89,815	(105,185)
2	84,000	0.8573	72,016	(33,169)
3	86,000	0.7938	68,270	35,101
4	75,000	0.7350	55,127	90,228
5	63,000	0.6806	42,877	133,105

Therefore PI for Equipment 2

= 328105 / 195000

= 1.68

Therefore based on Profitability Index the company should accept Equipment 1

b,

Discounted Payback Period = A +	B
C

Where,
A = Last period with a negative discounted cumulative cash flow;
B = Absolute value of discounted cumulative cash flow at the end of the period A; and
C = Discounted cash flow during the period after A.

Therefore Discounted Payback Period for Equipment 1

= 2 + 26638/65888

= 2 + 0.40

= 2.40 years

Discounted Payback Period for Equipment 2

= 2 + 33169/68270

= 2 + 0.49

= 2.49 years

Since the payback criterion is maximum 2 years, the company should not accept any of the above equipment since the discounted payback period for both the equipments is more than 2 years