Question

Dwight Donovan, the president of Solomon Enterprises, is considering two investment opportunities. Because of limited resources, he will be able to invest in only one of them. Project A is to purchase a machine that will enable factory automation; the machine is expected to have a useful life of three years and no salvage value. Project B supports a training program that will improve the skills of employees operating the current equipment. Initial cash expenditures for Project A are $115,000 and for Project B are $35,000. The annual expected cash inflows are $54,593 for Project A and $15,076 for Project B. Both investments are expected to provide cash flow benefits for the next three years. Solomon Enterprises’ desired rate of return is 6 percent. (PV of $1 and PVA of $1) (Use appropriate factor(s) from the tables provided.)

Answer 1

We need to calculate Net present value (NPV) of both the projects. the project which has higher positive NPV will be chosen because only one project can be chosen due to limited resources.

NPV is the difference between the sum of present value of cash inflows and initial cost or investment.

sum of present value of cash inflows = Year 1 cash inflow/(1+desired rate of return) + Year 2 cash inflow/(1+desired rate of return)² + Year 3 cash inflow/(1+desired rate of return)³

Project A should be chosen because it has higher positive NPV of $30,927.74.

Year	PV Factor	Project A	PV of Project A	Project B	PV of Project B
0	1	-$115,000	-$115,000.00	-$35,000	-$35,000.00
1	0.9434	$54,593	$51,502.83	$15,076	$14,222.64
2	0.8900	$54,593	$48,587.58	$15,076	$13,417.59
3	0.8396	$54,593	$45,837.34	$15,076	$12,658.10
desired rate of return		6%		6%
NPV			$30,927.74		$5,298.33

Calculations