Question

Brief Exercise 12-5

McKnight Company is considering two different, mutually exclusive capital expenditure proposals. Project A will cost $459,000, has an expected useful life of 11 years, a salvage value of zero, and is expected to increase net annual cash flows by $74,600. Project B will cost $274,000, has an expected useful life of 11 years, a salvage value of zero, and is expected to increase net annual cash flows by $46,200. A discount rate of 9% is appropriate for both projects. Click here to view PV table.

Compute the net present value and profitability index of each project. (If the net present value is negative, use either a negative sign preceding the number eg -45 or parentheses eg (45). Round present value answers to 0 decimal places, e.g. 125 and profitability index answers to 2 decimal places, e.g. 15.25. For calculation purposes, use 5 decimal places as displayed in the factor table provided.)

Net present value - Project A		$
Profitability index - Project A
Net present value - Project B		$
Profitability index - Project B

Which project should be accepted based on Net Present Value?

Project BProject A should be accepted.

Which project should be accepted based on profitability index?

Project AProject B should be accepted.

Answer 1

Project A

Initial investment = $459,000

Salvage value = $0

Annual cash inflow = $74,600

time period (n) = 11 year

Interest rate (i) = 9%

Present value of cash inflows = Annual cash inflow x Present value annuity factor ( i%,n)

= 74,600 x Present value annuity factor (9%,11)

= 74,600 x 6.80519

= $507,667

Net present value = Present value of cash inflows-Initial investment

= 507,667-459,000

= $48,667

Profitability index = Present value of cash inflows /Initial investment

= 507,667/459,000

= 1.11

Project B

Initial investment = $274,000

Salvage value = $0

Annual cash inflow = $46,200

time period (n) = 11 year

Interest rate (i) = 9%

Present value of cash inflows = Annual cash inflow x Present value annuity factor ( i%,n)

= 46,200 x Present value annuity factor (9%,11)

= 46,200 x 6.80519

= $314,400

Net present value = Present value of cash inflows-Initial investment

= 314,400-274,000

= $40,400

Profitability index = Present value of cash inflows /Initial investment

= 314,400/274,000

= 1.15

Project A should be accepted based on Net Present Value.

Project B should be accepted based on profitability index