A firm is considering 2 capital investment projects. Project A involves an initi

Question

A firm is considering 2 capital investment projects. Project A involves an initial cost of $125,000. The discounted present value of all future cash flows is $145,000. Project B requires an initial expenditure of $85,000. The discounted present value of all future cash flows is $102,000.

a. Calculate the net present value of each of the 2 projects. Which would be preferred according to the net present value criterion?

b. Calculate the profitability index of each of the 2 projects. Which would be preferred according to the profitability index criterion?

Explanation / Answer

ANSWER:

1) Net present value of project a = discounted future cash flows - initial cost = $145,000 - $125,000 = $20,000

Net present value of project b = discounted future cash flows - initial cost = $102,000 - $85,000 = $17,000

according to net present value we will choose project a.

2) Profitability index of project a = present value of future cash flows / initial cost = $145,000 / $125,000 = 1.16

Profitability index of project b = present value of future cash flows / initial cost = $102,000 / $85,000 = 1.2

according to profitability index we will choose project b.

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