Al a Mode, Inc., is considering one of two investment options. Option 1 is a $73

Question

Al a Mode, Inc., is considering one of two investment options. Option 1 is a $73,000 investment in new blending equipment that is expected to produce equal annual cash flows of $23,000 for each of seven years. Option 2 is a $79,000 investment in a new computer system that is expected to produce equal annual cash flows of $29,000 for each of five years. The residual value of the blending equipment at the end of the fifth year is estimated to be $15,000. 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

a)

b) Present Value Index = Present value of net cash flow / Initial Investment

Blending Equipment = 113477 / 73000 = 1.55

Computer Equipment = 104545 / 79000 = 1.32

New Blending Equipment Year Cash Flow PVF 12% PV 0     (73,000) 1          (73,000) 1        23,000 0.893             20,539 2        23,000 0.797             18,331 3        23,000 0.712             16,376 4        23,000 0.636             14,628 5        38,000 0.567             21,546 6        23,000 0.507             11,661 7        23,000 0.452             10,396 NPV             40,477

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