Question

Edelman Engineering is considering including two pieces of equipment, a truck and an overhead pulley system, in this year’s capital budget. The projects are independent. The cash outlay for the truck is $30,100, and that for the pulley system is 47135$. The firm’s cost of capital is 14%. After-tax cash flows, including depreciation, are as follows:

Expected Net Cash Flows

Year                Truck                         Pulley

1. (38700)                        8400
2. (19300)                        9400
3. (10000)                      10400
4. 60000                        11400
5. 60000                         12400
6. 85000                          13400
7. (18000)                        13400

Calculate the Payback period, NPV and PI for both and comment on accept/reject decision for each.

Answer 1

Payback period is the time taken by a project's after-tax cash inflows to recover its initial investment. For Truck, we can see in column C Cumu. cash flow it recovers -$8,000 by year 4. so remaining initial investment of $30,100 - (-$8,000) = $30,100 + $8,000 = $38,100 it will recover from $60,000 cash inflow of year 5.

Payback period for Truck = 4 years + ($38,100/$60,000) = 4 years + 0.64 years = 4.64 years.

NPV is the difference between present value of after-tax cash inflows and initial investment.

present value of after-tax cash inflows = Year 1 after-tax cash inflows/(1+cost of capital) + Year 2 after-tax cash inflows/(1+cost of capital)² + Year 3 after-tax cash inflows/(1+cost of capital)³ .... + Year 7 after-tax cash inflows/(1+cost of capital)⁷

PI is the ratio of present value of after-tax cash inflows to initial investment. A PI of more than 1 indicates a project is profitable.

Year	Truck	Cumu. Cash flow	Pulley	Cumu. Cash flow
0	-$30,100		-$47,135
1	-$38,700	-$38,700	$8,400	$8,400
2	-$19,300	-$58,000	$9,400	$17,800
3	-$10,000	-$68,000	$10,400	$28,200
4	$60,000	-$8,000	$11,400	$39,600
5	$60,000	$52,000	$12,400	$52,000
6	$85,000	$137,000	$13,400	$65,400
7	-$18,000	$119,000	$13,400	$78,800
Cost of Capital	14.00%		14.00%
Payback Period (in years)	4.64		4.61
NPV	$12,570.51		-$863.99
PI	1.42		0.98

Truck project should be accepted because it has positive NPV and PI of more than 1. a positive NPV and PI of more than 1 indicates this project is profitable.

Pulley project should be rejected because it has negative NPV and PI of less than 1. a negative NPV and PI of less than 1 indicates this project is not profitable.