Question

Brief Exercise 12-5 McKnight Company is considering two different, mutually exclusive capital expenditure proposals. Project A will cost $461,000, has an expected useful life of 11 years, a salvage value of zero, and is expected to increase net annual cash flows by $68,000. Project B will cost $297,000, has an expected useful life of 11 years, a salvage value of zero, and is expected to increase net annual cash flows by $45,000. A discount rate of 7% 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.)

Answer 1

Project A:

Initial Cost = $461,000
Annual Net Cash Flows = $68,000
Useful Life = 11 yeas
Discount Rate = 7%

Present Value of Cash Inflows = $68,000 * PVA of $1 (7%, 11)
Present Value of Cash Inflows = $68,000 * 7.49867
Present Value of Cash Inflows = $509,910

Net Present Value = Present Value of Cash Inflows - Initial Cost
Net Present Value = $509,910 - $461,000
Net Present Value = $48,910

Profitability Index = Present Value of Cash Inflows / Initial Cost
Profitability Index = $509,910 / $461,000
Profitability Index = 1.11

Project B:

Initial Cost = $297,000
Annual Net Cash Flows = $45,000
Useful Life = 11 yeas
Discount Rate = 7%

Present Value of Cash Inflows = $45,000 * PVA of $1 (7%, 11)
Present Value of Cash Inflows = $45,000 * 7.49867
Present Value of Cash Inflows = $337,440

Net Present Value = Present Value of Cash Inflows - Initial Cost
Net Present Value = $337,440 - $297,000
Net Present Value = $40,440

Profitability Index = Present Value of Cash Inflows / Initial Cost
Profitability Index = $337,440 / $297,000
Profitability Index = 1.14