Al a Mode, Inc., is considering one of two investment options. Option 1 is a $34

Question

Al a Mode, Inc., is considering one of two investment options. Option 1 is a $34,000 investment in new blending equipment that is expected to produce equal annual cash flows of $11,000 for each of seven years. Option 2 is a $38,000 investment in a new computer system that is expected to produce equal annual cash flows of $14,000 for each of five years. The residual value of the blending equipment at the end of the fifth year is estimated to be $7,000. The computer system has no expected residual value at the end of the fifth year.

Assume there is sufficient capital to fund only one of the projects. Determine which project should be selected, comparing the (a) net present values and (b) present value indices of the two projects, assuming a minimum rate of return of 12%. Use the present value tables appearing above.

a. Determine the net present values of the two projects.

b. Determine the present value indices of the two projects. If required, round the present value index to two decimal places.

Present Value of $1 at Compound Interest Year 6% 10% 12% 15% 20% 1 0.943 0.909 0.893 0.870 0.833 2 0.890 0.826 0.797 0.756 0.694 3 0.840 0.751 0.712 0.658 0.579 4 0.792 0.683 0.636 0.572 0.482 5 0.747 0.621 0.567 0.497 0.402 6 0.705 0.564 0.507 0.432 0.335 7 0.665 0.513 0.452 0.376 0.279 8 0.627 0.467 0.404 0.327 0.233 9 0.592 0.424 0.361 0.284 0.194 10 0.558 0.386 0.322 0.247 0.162

Explanation / Answer

Ans 1 Blending Equipment Computer System Total present value of cash flows 43624 50470 Less amount to be invested 34000 38000 Net present value                      $ 9624 12470 Computer Sysytem is better as it has greater NPV than computer sysytem Blending Equipment Computer System Total present value of cash flows Cash Inflows C 11000 14000 No.of years (but effective life 5 years) 7 5 Present Value of an Annuity of $1 at Compound Interest P for 5 years 3.605 3.605 P.V of Cash Inflows C*P 39655 50470 Salvage value 7000 Present Value of $1 at Compound Interest at 5th year 0.567 PV of salvage value 3969 Total present value of cash flows 43624 50470 Present Value Index Present Value of net cash inflows/Initial Investment Blending Equipment 43624/34000 1.28 Computer System 50470/38000 1.33 Note: as computer sysytem has 5 years life and residual value of blendingequipment is given at the end of 5 years so we are comparing for 5 years

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