Question

Krueger Activity

Krueger Activity - Comparing and Prioritizing Multiple Projects

Krueger Inc. has two potential capital investment projects. Both projects have made it through the screening process and now Krueger has to choose between the two projects. Due to the varying investment amounts and time horizons, selecting the best project has been difficult.

For Each Project, Assume Krueger has a Tax Rate of 15%

Project 1: Updating the Machines in the Manufacturing Facility

Initial cash paid for new machines is $10,000,000

Krueger will be able to dispose of the old equipment it previously used for $1,000,000 (At no Gain/Loss)

The project will generate NOI of $900,000 per year (Excluding maintenance costs)

New machines have a useful life of 8 years and a salvage value of $1,200,000

Major maintenance is needed on the machine in Year 5, $500,000

Project 2: Purchase an ERP Software System (Enterprise Resource Planning System)

Initial Investment in software $2,000,000

Initial Installation and training $2,000,000

Annual maintenance costs are $180,000

Cost (cash) savings from the software before maintenance cost, $1,000,000.

Useful life of the software- 10 years with no salvage value

Required for each project:

Using a discount rate of 10%, calculate the NPV of your project.

Determine the profitability index of your project.

Determine your project’s payback period

Prepare a brief memo with your recommendation on which investment project the company should chose.

Answer 1

Project 1: 1 2 3 4 5 6 7 8 Initial Investment Period 1 Period 2 Period 3 Period 4 Period 5 Period 6 Period 7 Period 8 Cash Paid for Machine ($10,000,000) Sale of Old Machine $1,000,000 Net Operating Income $900,000 $900,000 $900,000 $900,000 $900,000 $900,000 $900,000 $900,000 Less: Maintenance $0 $0 $0 $0 ($500,000) $0 $0 $0 Less: Tax (15%) ($135,000) ($135,000) ($135,000) ($135,000) ($60,000) ($135,000) ($135,000) ($135,000) Add: Salvage Value $1,200,000 Net Cash Flow ($9,000,000) $765,000 $765,000 $765,000 $765,000 $340,000 $765,000 $765,000 $1,965,000 Cumulative Cash Flow $765,000 $1,530,000 $2,295,000 $3,060,000 $3,400,000 $4,165,000 $4,930,000 $6,895,000 Discount Rate 10% PV factor 1.0000 0.9091 0.8264 0.7513 0.6830 0.6209 0.5645 0.5132 0.4665 Present Value ($9,000,000) $695,455 $632,231 $574,756 $522,505 $211,113 $431,823 $392,566 $916,687 NPV ($4,622,864) Profitability Index 0.49 Profitability Index = (PV of future cash flows) ÷ Initial investment Payback Period 11.76 Payback Period= cost of the investment / Annual Cash Flow Project 2: 1 2 3 4 5 6 7 8 9 10 Initial Investment Period 1 Period 2 Period 3 Period 4 Period 5 Period 6 Period 7 Period 8 Period 9 Period 10 Initial Investment in software ($2,000,000) Initial Installation and training ($2,000,000) Net Operating Income $1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000 Less: Tax (15%) ($150,000) ($150,000) ($150,000) ($150,000) ($150,000) ($150,000) ($150,000) ($150,000) ($150,000) ($150,000) Less: Annual Maintenance ($180,000) ($180,000) ($180,000) ($180,000) ($180,000) ($180,000) ($180,000) ($180,000) ($180,000) ($180,000) Net Cash Flow ($4,000,000) $670,000 $670,000 $670,000 $670,000 $670,000 $670,000 $670,000 $670,000 $670,000 $670,000 Cumulative Cash Flow $670,000 $1,340,000 $2,010,000 $2,680,000 $3,350,000 $4,020,000 $4,690,000 $5,360,000 $6,030,000 $6,700,000 Discount Rate 10% PV factor 1.0000 0.9091 0.8264 0.7513 0.6830 0.6209 0.5645 0.5132 0.4665 0.4241 0.3855 Present Value ($4,000,000) $609,091 $553,719 $503,381 $457,619 $416,017 $378,198 $343,816 $312,560 $284,145 $258,314 NPV $116,860 Profitability Index 1.03 Profitability Index = (PV of future cash flows) ÷ Initial investment Payback Period $5.97 Payback Period= cost of the investment / Annual Cash Flow
Our recommendation Project 2 is the clear winner as the project 1 will suffer from loss. The Company should choose Project 2 over project 1 because of the following reasons: NPV of project 2 is greater than NPV of project 1, NPV of project 1 is in negative PI, which is nothing but an extension of NPV, of project 2 is greater than PI of project 1 Though payback period doesn’t consider time value of money but it is a good measure to check the reasonable of the decision taken based on above two points. Project 2 has a shorter payback period.