Question

1. Schultz Manufacturing is considering two alternative investment proposals with the following details:

	Proposal A	Proposal B
Investment, today	$550,000	$275,000
Useful life	5 years	4 years
Estimated annual net cash inflows	$150,000	$90,000
Residual value	$50,000	$0
Depreciation method	Straight-line	Straight-line
Discount rate	10%	9%

1. You have been hired as a capital budgeting expert. You are to recommend to the senior management of Schultz the best investment option. What proposal do you recommend? You must support your answer. Please show all work.
2. Schultz has informed you that they are concerned about the discount rate for both proposals. In fact, Schultz fears that they might be 200 basis points off on the discount rate for both proposals. Does this information have any effect on your decision for part (a.)? You must support your answer. Please show all work

Answer 1

Evaluation of the projects can be done by using net present value, If Net present value is positive then that project is selected. If the both projects have a positive NPV and projects are mutually exclusive then compare the NPV figures and select the project with higher NPV.

Proposal A:

Year	(a) Estimated annual net cash inflows	(b) PVF @ 10%	Present value (a*b)
1	$ 1,50,000	0.909	$ 1,36,350
2	$ 1,50,000	0.826	$ 1,23,900
3	$ 1,50,000	0.751	$ 1,12,650
4	$ 1,50,000	0.683	$ 1,02,450
5	$ 1,50,000	0.621	$ 93,150
5	$ 50,000	0.621	$ 31,050
		Total present value of cash inflows	$ 5,99,550

Present value of cash outflows = $ 5,50,000

Net present value = Present value of cash inflows - Present value of cash outflows

= $ 5,99,550 - $ 5, 50,000

= $ 49,550

Proposal B:

Year	(a) Estimated annual net cash inflows	(b) PVF @ 9%	Present value (a*b)
1	$ 90,000	0.917	$ 82,530
2	$ 90,000	0.842	$ 75,780
3	$ 90,000	0.772	$ 69,480
4	$ 90,000	0.708	$ 63,720
		Total present value of cash inflows	$ 2,91,510

Present value of cash outflows = $ 2,75,000

Net present value = Present value of cash inflows - Present value of cash outflows

= $ 2,91,510 - $ 2,75,000

= $ 16,510

Both projects have a positive NPV and projects are mutually exclusive then compare the NPV figures.and select the project with higher NPV. Here Proposal A have higher NPV of $ 49,550 will be selected.

b) Revised discount rate for proposal A is 8%(10%-2%) and for proposal B is 7%(9%-2%)

Proposal A:

Present value of cash inflows = Annual net cash inflows * PVAF(8%, 5 years) + Terminal cash inflows * PVF(8%, 5th year)

= $ 1,50,000 * 3.9927 + $ 50,000 * 0.681

= $ 5,98,905 + $ 34,050

= $ 6,32,955

Present value of cash outflows = $ 5,50,000

Net present value = Present value of cash inflows - Present value of cash outflows

= $ 6,32,955 - $ 5, 50,000

= $ 82,955

Proposal B:

Present value of cash inflows = Annual net cash inflows * PVAF(7%, 5 years)

= $ 90,000 * 3.387

= $ 3,04,830

Present value of cash outflows = $ 2,75,000

Net present value = Present value of cash inflows - Present value of cash outflows

= $ 3,04,830 - $ 2,75,000

= $ 29,830

Proposal A has higher NPF of $ 82,955 will be selected. Decision on selecting the proposal will not change. But the NPV of proposal A is $ 33,405 more than the NPV at 10% discount rate.