Question
In: Accounting
Vista Company is considering two new projects, each requiring an equipment investment of $97,000. Each project...
Vista Company is considering two new projects, each requiring an equipment investment of $97,000. Each project will last for three years and produce the following cash inflows:
Year Cool Hot
1 $ 38,000 $ 42,000
2 43,000 42,000
3 48,000 42,000
$129,000 $126,000
The equipment will have no salvage value at the end of its three-year life. Vista Company uses straight-line depreciation and requires a minimum rate of return of 12%.
Present value data are as follows:
Present Value of 1 Present Value of an Annuity of 1
Period 12% Period 12%
1 .893 1 .893
2 .797 2 1.690
3 .712 3 2.402
Instructions
(a) Compute the net present value of each project.
(b) Compute the profitability index of each project.
(c) Which project should be selected? Why?
Additional requirement:
Calculate the Cash Payback period of each project
Solutions
Expert Solution
| Answer a | ||||||||
| Calculation of the net present value of each project | ||||||||
| Year | Discount Factor @ 12% | Cool | Hot | |||||
| Cash flow | present Value | Cash flow | present Value | |||||
| 0 | 1 | -$97,000.00 | -$97,000.00 | -$97,000.00 | -$97,000.00 | |||
| 1 | 0.893 | $38,000.00 | $33,928.57 | $42,000.00 | $37,500.00 | |||
| 2 | 0.797 | $43,000.00 | $34,279.34 | $42,000.00 | $33,482.14 | |||
| 3 | 0.712 | $48,000.00 | $34,165.45 | $42,000.00 | $29,894.77 | |||
| Net Present Value | $5,373.36 | $3,876.91 | ||||||
| NPV of Project Cool = | $5,373.36 | |||||||
| NPV of Project Hot = | $3,876.91 | |||||||
| Answer b | ||||||||
| Profitability Index of a project = Present value of future cash inflows / Initial Investment in project | ||||||||
| Profitability Index of a Project Cool = $102,373.36 / $97,000 = 1.06 | ||||||||
| Profitability Index of a Project Hot = $100,876.91 / $97,000 = 1.04 | ||||||||
| Answer c | ||||||||
| Project Cool should be selected as it has higher NPV and PI compared to Project Hot. | ||||||||
| Answer d | ||||||||
| Calculation of Cash payback period | ||||||||
| Year | Cool | Hot | ||||||
| Cash flow | Cumulative Cash Flow | Cash flow | Cumulative Cash Flow | |||||
| 0 | -$97,000.00 | -$97,000.00 | -$97,000.00 | -$97,000.00 | ||||
| 1 | $38,000.00 | -$59,000.00 | $42,000.00 | -$55,000.00 | ||||
| 2 | $43,000.00 | -$16,000.00 | $42,000.00 | -$13,000.00 | ||||
| 3 | $48,000.00 | $32,000.00 | $42,000.00 | $29,000.00 | ||||
| Cash payback period of Project Cool = 2 Years + [$16000 / $48000] = 2.33 years | ||||||||
| Cash payback period of Project Hot = 2 Years + [$13000 / $42000] = 2.31 years | ||||||||
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