Question

Home Ltd. has the option of investing in the following two projects of equal risk; they are mutually exclusive alternatives for expanding the firm’s capacity.  The firm’s cost of capital is 12%.  The cash flows for each project are given in the following table.

	PROJECT A	PROJECT B
Initial investment	545,000	300,000
Year	Net cash inflows	Net cash inflows
1	135,000	200,000
2	185,000	120,000
3	220,000	92,000
4	280,000

Home Ltd. has incurred a research and development expenditure of $35,000 initially for project A and $25,000 for project B, both of which are considered sunk costs for the business. Due to seasonal demand, business believes for project A only, they will have to incur additional electricity charge of $1,000 each year till year 4. At the end of year 4, the business believes that they could sell project A for $60,000 and at the end of year 3, project B for $50,000. The finance manager has also suggested that any investment that takes more than 4 years to pay back the initial investment should be rejected.

1: Calculate the net present value for each project.  Using the net present value criterion, which project is preferable and why?

2: Calculate the payback period of each project. Using the payback period criterion which project is preferable and why?

3: Calculate the profitability index for each project.  Using the profitability index criterion which project is acceptable and why?

4: Calculate equivalent annual value for each project. Using the equivalent annual value method which project is acceptable and why?

Answer 1

(a) Calculation of Net present value

Since the NPV of Project A is higher as compared to NPV of Project B, hence Project A should be selected.

(b) Calculation of payback period

	Net cash flows	Simple cumulative cash flows
Year	Project A	Project B	Project A	Project B
0	(545,000)	(300,000)	(545,000)	(300,000)
1	134,000	200,000	(411,000)	(100,000)
2	184,000	120,000	(227,000)	20,000
3	219,000	142,000	(8,000)	162,000
4	339,000	-	331,000	-

Payback period of Project A = 3 + (8,000 / 339,000)

= 3.02 years

Payback period of Project B = 1 +(100,000 / 120,000)

= 1.83 years

Lower the payback period, better the investment project. Hence Project B should be selected.

(c) Calculation of profitability index

Profitability index of Project A = Present value of cash inflows / Initial investment

= 637,647 / 545,000

= 1.17

Profitability index of Project B = Present value of cash inflows / Initial investment

= 375,307 / 300,000

= 1.25

Higher the profitability index, better the investment project. Hence Project B should be selected.

(d) Calculation of equivalent annual value of each project

Equivalent annual value of Project A = NPV of Project A / PVAF(12%, 4 years)

= 92,647 / 3.0373

= $30,502.59

Equivalent annual value of Project B = NPV of Project B / PVAF(12%, 3 years)

= 75,307 / 2.4018

= $31,354.20

Since the equivalent annual value of Project B is higher than Project A, hence Project B should be selected.