Question

Question 5

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? (4 marks)
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

The profitability index of Equipment 1 is computed as shown below:

= Present value of future cash flows / Initial investment

Present value is computed as follows:

= Future value / (1 + r)ⁿ

= $ 86,000 / 1.08¹ + $ 93,000 / 1.08² + $ 83,000 / 1.08³ + $ 75,000 / 1.08⁴ + $ 55,000 / 1.08⁵

= $ 317,809.5307

So, the profitability index of Equipment 1 will be as follows:

= $ 317,809.5307 / $ 186,000

= 1.7087

The profitability index of Equipment 2 is computed as shown below:

= Present value of future cash flows / Initial investment

Present value is computed as follows:

= Future value / (1 + r)ⁿ

= $ 97,000 / 1.08¹ + $ 84,000 / 1.08² + $ 86,000 / 1.08³ + $ 75,000 / 1.08⁴ + $ 63,000 / 1.08⁵

= $ 328,104.8288

So, the profitability index of Equipment 2 will be as follows:

= $ 328,104.8288 / $ 195,000

= 1.6826

Since the PI of Equipment 1 is greater than the PI of Equipment 2, hence Equipment 1 shall be selected.

b. The discounted payback period of Equipment 1 is computed as shown below:

Cumulative discounted cash flows from year 1 to year 2 is computed as follows:

= $ 86,000 / 1.08¹ + $ 93,000 / 1.08²

= $ 159,362.1399

Cumulative discounted cash flows from year 1 to year 3 is computed as follows:

= $ 86,000 / 1.08¹ + $ 93,000 / 1.08² + $ 83,000 / 1.08³

= $ 225,250.2159

It implies that the discounted payback period lies between year 2 and year 3, as the initial investment of $ 186,000 is recovered between them. So, the discounted payback period will be computed as follows:

= 2 years + Balance investment to be recovered / Year 3 discounted cash flow

= 2 years + [ ($ 186,000 - $ 159,362.1399) / ( $ 83,000 / 1.08³) ]

= 2 years + $ 26,637.8601 / $ 65,888.076

= 2.40 years Approximately

The discounted payback period of Equipment 2 is computed as shown below:

Cumulative discounted cash flows from year 1 to year 2 is computed as follows:

= $ 97,000 / 1.08¹ + $ 84,000 / 1.08²

= $ 161,831.2757

Cumulative discounted cash flows from year 1 to year 3 is computed as follows:

= $ 97,000 / 1.08¹ + $ 84,000 / 1.08² + $ 86,000 / 1.08³

= $ 230,100.8484

It implies that the discounted payback period lies between year 2 and year 3, as the initial investment of $ 195,000 is recovered between them. So, the discounted payback period will be computed as follows:

= 2 years + Balance investment to be recovered / Year 3 discounted cash flow

= 2 years + [ ($ 195,000 - $ 161,831.2757) / ( $ 86,000 / 1.08³) ]

= 2 years + $ 33,168.7243 / $ 68,269.57273

= 2.49 years Approximately

Since the discounted payback period of both the equipment is greater than 2 years, hence none of these projects shall be accepted.

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