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: a) Identify which option of equipment should the company accept based on Profitability Index? b) Identify which option of equipment should the company accept based on discounted pay back method if the payback criterion is maximum 2 years?

please i want answer in word not in excel

Answer 1

(a)

Profitability Index = Present value of Fututre cash flow / Initial Investment

Year	Equipment 1 cash flow	Equipment 2 cash flow
1	86000	97000
2	93000	84000
3	83000	86000
4	75000	75000
5	55000	63000

required rate of return for all investment projects is 8%

Present value = Future value / (1+i)^t

Present value of Future Cash flows of Equipment -1 =

=> Present value of Future Cash flows of Equipment -1= $317809.531

Initial Investment of Equipment-1 = $186,000

Profitability Index Of Equipment -1 = $317809.531 / $186,000

=>Profitability Index Of Equipment -1= 1.71

it means Equipment 1 will generate $1.71 Per $1 investment.

Present value of Future Cash flows of Equipment -2 =

=>Present value of Future Cash flows of Equipment -2= $328104.829

Initial Investment of Equipment-2 = $195,000

Profitability Index Of Equipment -2 = $328104.829 / $195,000

=>Profitability Index Of Equipment -2= 1.68

it means Equipment 2 will generate $1.68 Per $1 investment.

hence Equipment 1 Should be accepted based on Profitability Index as it has Higher profitability index..

Tabular form-

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(b)

Discounted pay back period = A+B/C

A = Last period with a negative cumulative discounted cash flow

B = Absolute value( Without negative sign) of the discounted cumulative cash flow at the end of period A

C = Discounted cash flow after period A.

(I) Discounted pay back for Equipment-1

.	A	B	A*B	.
Year	Cash flow	PVF@8%	Present value of cash flow or discounted cash flow	Cumulative discounted cash flow
0	-186000	1.00000000	-186000.000	-186000.000
1	86000	0.92592593	79629.630	-106370.370
2(A)	93000	0.85733882	79732.510	-26637.860 (B)
3	83000	0.79383224	65888.076(C)	39250.216
4	75000	0.73502985	55127.239	94377.455
5	55000	0.68058320	37432.076	131809.531

Discounted pay back period Of equipment-1 = 2+ [26637.860/65888.076] = 2.40 Years.

(II) Discounted pay back for Equipment-2

	A	B	A*B	.
Year	Cash flow	PVF@8%	Present value of cash flow or discounted cash flow	Cumulative discounted cash flow
0	-195000	1.00000000	-195000.000	-195000.000
1	97000	0.92592593	89814.815	-105185.185
2(A)	84000	0.85733882	72016.461	-33168.724(B)
3	86000	0.79383224	68269.573(C)	35100.848
4	75000	0.73502985	55127.239	90228.087
5	63000	0.68058320	42876.741	133104.829

Discounted pay back period Of equipment-2 = 2+ [33168.724/68269.573] = 2.49 Years.

maximum pay back required = 2 years

As both the equipment has discounted pay back period of more than 2 year, hence NONE of the equipment should be accepted based on discounted pay back method