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:

1. a) Identify which option of equipment should the company accept based on Profitability Index?

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

Answer 1

(A)

Profitability index = (Present value of Future Cash flows)/ (Initial Investement)

			Equipment 1	Equipment 2
	A		B	A*B	C	A*C
Year	Present value Factor@8%		Equipment 1 Future cash flows	Present value of the cashflow	Equipment 2 Future cash flows	Present value of the cashflow
1	0.9259259259	=1/(1.08)^1	86000	79629.63	97000	89814.81
2	0.8573388203	=1/(1.08)^2	93000	79732.51	84000	72016.46
3	0.793832241	=1/(1.08)^3	83000	65888.08	86000	68269.57
4	0.7350298528	=1/(1.08)^4	75000	55127.24	75000	55127.24
5	0.680583197	=1/(1.08)^5	55000	37432.08	63000	42876.74
			Total PV of the Future Cash flow	317809.53		328104.83

	Equipment 1	Equipment 2
Total PV of the Future Cash flow(A)	317809.53	328104.83
Initial Investment(B)	186000	195000
Profitability index(A/B)	1.709	1.683

.based on Profitability Index, Equipment -1 should be accepted , because it will able to generate additional $0.709 per $1 invested. But Equpiment -2, can only generate additional $0.683 per $1 invested.

Hence Equipment -1 should be accepted.

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(b)

Discounted pay back period = A+ B/C

A = Last period with negative Cumulative discounted cash flow

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

C= Discounted cash flow for period after period A

EQUIPMENT 1
	A	B	A*B
Year	Present value Factor@8%	Cashflow	Present value of the cashflow	Cumulative cash flow
0	1	-186000	-186000.00	-186000.00
1	0.9259259259	86000	79629.63	-106370.37
2(A)	0.8573388203	93000	79732.51	-26637.86(B)
3	0.793832241	83000	65888.08(C)	39250.22
4	0.7350298528	75000	55127.24	94377.45
5	0.680583197	55000	37432.08	131809.53

Discounted pay back period of Equipment 1=  2+(26637.86/65888.08) = 2.40 Years.

EQUIPMENT 2
	A	B	A*B
Year	Present value Factor@8%	Cashflow	Present value of the cashflow	Cumulative cash flow
0	1	-195000	-195000.00	-195000.00
1	0.9259259259	97000	89814.81	-105185.19
2(A)	0.8573388203	84000	72016.46	-33168.72(B)
3	0.793832241	86000	68269.57(C)	35100.85
4	0.7350298528	75000	55127.24	90228.09
5	0.680583197	63000	42876.74	133104.83

Discounted pay back period of Equipment 2=  2+(33168.72/68269.57) = 2.49 Years.

For both the equipment the Discounted pay back period is more than 2 years, but the maximum payback criterion is 2 years.

Hence No equipment option is Acceptable based on Discount pay back period