Question

A company has the opportunity to do any, none, or all of the projects for which the net cash flows per year are shown below. The company has a cost of capital of 14%. Which should the company do and why? You must use at least two capital budgeting methods. Show your work.

Year	A	B	C
0	-300	-150	-350
1	100	50	100
2	100	100	100
3	100	100	100
4	100	100	100
5	100	100	100
6	50	100	100
7	100	200	0

Answer 1

Here, we can use Net Present Value and Profitability Index Capital Budgeting Techniques to Evaluate the Projects

Net Present Value [NPV] Method

Project - A

Year	Cash Inflow ($)	Present Value Factor at 14%	Present Value of cash flow ($)
1	100	0.87719	87.72
2	100	0.76947	76.95
3	100	0.67497	67.50
4	100	0.59208	59.21
5	100	0.51937	51.94
6	50	0.45559	22.78
7	100	0.39964	39.96
			$ 406.06

Net Present Value = Present Value of cash inflows – Initial Investments

= $406.06 – $300

= $106.06

Project - B

Year	Cash Inflow ($)	Present Value Factor at 14%	Present Value of cash flow ($)
1	50	0.87719	43.86
2	100	0.76947	76.95
3	100	0.67497	67.50
4	100	0.59208	59.21
5	100	0.51937	51.94
6	100	0.45559	45.56
7	200	0.39964	79.93
			$424.95

Net Present Value = Present Value of cash inflows – Initial Investments

= $424.95 - $150

= $274.95

Project - C

Year	Cash Inflow ($)	Present Value Factor at 14%	Present Value of cash flow ($)
1	100	0.87719	87.72
2	100	0.76947	76.95
3	100	0.67497	67.50
4	100	0.59208	59.21
5	100	0.51937	51.94
6	100	0.45559	45.56
7	0	0.39964	0
			$ 388.88

Net Present Value = Present Value of cash inflows – Initial Investments

= $388.88 – $350

= $38.88

Decision based on Net Present Value (NPV) Method

On the results of the above capital budgeting techniques, The Company has to select the PROJECT-B Since it has a high Net Present Value of $274.95 as compared to PROJECT-A [$106.06] and PROJECT-C [$38.88].

Profitability Index Method

Profitability Index = Value of cash inflows / Initial Investments

Project A = $406.06 / 300 = 1.35

Project B = $424.95 / 150 = 2.83

Project C = $388.88/ 350 = 1.11

Decision based on Profitability Index Method

As per Profitability Index Method, Project B is acceptable, It means that for every $1 of cash flow, it will give the $2.83 of Net Present Value.

NOTE

The Formula for calculating the Present Value Factor is [1/(1 + r)ⁿ], Where “r” is the Discount/Interest Rate and “n” is the number of years.