Question

Hook Industries is considering the replacement of one of its old drill presses. Three alternative replacement presses are under consideration. The relevant cash flows associated with each Press are shown in the following table. The firm’s cost of capital is 15%.

	Press A	Press B	Press C
Initial Investment (Y0)	$85,000	$60,000	$130,000
Year	Cash Inflows
1	$18,000	$12,000	$50,000
2	$18,000	$14,000	$30,000
3	$18,000	$16,000	$20,000
4	$18,000	$18,000	$20,000
5	$18,000	$20,000	$20,000
6	$18,000	$25,000	$30,000
7	$18,000	---	$40,000
8	$18,000	---	$50,000

1. Calculate the net present value (NPV) of each press.

b. Using NPV, evaluate the acceptability of each press.

c. Rank the presses from best to worst using NPV.

d. Calculate the profitability index (PI) for each press.

e. Rank the presses from best to worst using PI.

Answer 1

a.Press A

Net present value can be solved using a financial calculator. The steps to solve on the financial calculator:

• Press the CF button.
• CF0= -$85,000. Indicate the initial cash flow by a negative sign since it is a cash outflow.  
• Cash flow for each year should be entered.
• Press Enter and down arrow after inputting each cash flow.
• After entering the last cash flow cash flow, press the NPV button and enter the cost of capital of 15%.
• Press enter after that. Press the down arrow and CPT buttons to get the net present value.  

Net present value at 15% cost of capital is -$4,228,21.

Press B

Net present value can be solved using a financial calculator. The steps to solve on the financial calculator:

• Press the CF button.
• CF0= -$60,000. Indicate the initial cash flow by a negative sign since it is a cash outflow.  
• Cash flow for each year should be entered.
• Press Enter and down arrow after inputting each cash flow.
• After entering the last cash flow cash flow, press the NPV button and enter the cost of capital of 15%.
• Press enter after that. Press the down arrow and CPT buttons to get the net present value.  

Net present value at 15% cost of capital is $2,584.34.

Press C

Net present value can be solved using a financial calculator. The steps to solve on the financial calculator:

• Press the CF button.
• CF0= -$130,000. Indicate the initial cash flow by a negative sign since it is a cash outflow.  
• Cash flow for each year should be entered.
• Press Enter and down arrow after inputting each cash flow.
• After entering the last cash flow cash flow, press the NPV button and enter the cost of capital of 15%.
• Press enter after that. Press the down arrow and CPT buttons to get the net present value.  

Net present value at 15% cost of capital is $15,043.89.

b.Project A cannot be accepted since it generates a negative net present value.

Project B and C can be accepted since it generates a positive net present value.

c.Ranking the presses using NPV:

1.Project C

2.Project B

3.Project A

d.Project A

Profitability Index is a ratio of the discounted cash flow to the initial cash flow of the project. It is calculated using the below formula:

Profitability Index= NPV + Initial investment/ Initial investment

= -$4,228,21 + $85,000/ $85,000

= 80,771.79/  $85,000

= $0.95.

Project B

Profitability Index is a ratio of the discounted cash flow to the initial cash flow of the project. It is calculated using the below formula:

Profitability Index= NPV + Initial investment/ Initial investment

= $2,584.34 + $60,000/ $60,000

= $62,584.34/ $60,000

= 1.04.

Project C

Profitability Index is a ratio of the discounted cash flow to the initial cash flow of the project. It is calculated using the below formula:

Profitability Index= NPV + Initial investment/ Initial investment

= $15,043.89 + $130,000/ $130,000

= $145,043.89/ $130,000

= 1.12.

e.Ranking the presses using PI:

1.Project C

2.Project B

3.Project A

In case of any query, kindly comment on the solution.