Question

A company is considering two mutually exclusive projects. Initial investment for Project A (IRR=32%) is 15,000 and for B (IRR=28%) 18,000. For both projects, life time of the projects is 5 years, required rate of return for both the projects is 10%. The net cash flows before the tax and depreciation are as given in the table below. For both projects tax of 40% on cash inflows is to be charged.

Year	1	2	3	4	5
Project A	7000	9000	7000	6000	7000
Project B	5000	4000	12000	13000	12000

Calculate the NPV and Profitability index for each project. Which project would be selected and why?

Answer 1

Cash flows after taxes = (Net Cash Flows before Tax and Depreciation ) x ( 1 - t ) + Depreciation x t.

Project A:

Year	Cash Flows before Taxes and Depreciation	Depreciation	After-Tax Cash Flows	PV Factor at 10 %	Present Values
1	$ 7,000	$ 3,000	$ 5,400	0.90909	$ 4,909.09
2	9,000	3,000	6,600	0.82645	5,454.57
3	7,000	3,000	5,400	0.75131	4,057.07
4	6,000	3,000	4,800	0.68301	3,278.45
5	7,000	3,000	5,400	0.62092	3,352.97
Present Value of Cash Inflows					21,052.15
Initial Investment					15,000
NPV					$ 6,052.15
Profitability Index ( Present Value of Cash Inflows / Initial Investment)					1.403

Project B:

Year	Cash Flows before Taxes and Depreciation	Depreciation	After-tax Cash Flows	PV Factor at 10 %	Present Values
1	$ 5,000	$ 3,600	$ 4,440	0.90909	$ 4,036.36
2	4,000	3,600	3,840	0.82645	3,173.57
3	12,000	3,600	8,640	0.75131	6,491.32
4	13,000	3,600	9,240	0.68301	6,311.01
5	12,000	3,600	8,640	0.62092	5,364.75
Present Value of Cash Inflows					$ 25,377.01
Initial Investment					18,000
NPV					7,377.01
Profitability Index					1.410

Project B should be selected on the basis of higher NPV and higher Profitability Index.