Question

JJ Company has hired a consultant to propose a way to increase the company’s revenues. The consultant has evaluated two mutually exclusive projects with the following information provided for each project: Project Turtle Project Snake Capital investment $790,000 $440,000 Annual cash flows 130,000 75,000 Estimated useful life 10 years 10 years JJ Company uses a discount rate of 9% to evaluate both projects. Instructions 1. Calculate the net present value of both projects. 2. Calculate the profitability index for each project. 4. Calculate the Payback period for each project. 3. Which project should JJ accept and why?

Answer 1

1. Computation of Net Present Value:

Turtle Project

Present Value Interest Factors for a One-Dollar Annuity Discounted at 9% for 10 Periods i.e. PVAF = 6.4177

Net present value = Annual Cash Flows * PVAF

= $130,000*6.4177 = $834,301

Project Snake

Net present value = Annual Cash Flows * PVAF

= $75,000*6.4177 = $481,327

2. Computation of Profitability Index

Profitability Index = P.V of Future Cash Flows/Initial Investment

Turtle Project

Profitability Index = $834,301/$790,000 = 1.056

Snake Project

Profitability Index = $481,327/$440,000 = 1.093

3. Computation of Payback period

Payback period = Initial Investments/Cash Inflows

Turtle Project

Payback period = $790,000/$130,000 = 6.07 years

Snake Project

Payback period = $440,000/$75,000 = 5.87 years

Payback period in capital budgeting refers to the time required to recoup the funds expended in an investment, or to reach the break-even point. Therefore,ratio is lower the better.

4.

As the profitability index and payback period are better of snake project than Turtle project, therefore company should accept the snake project.