Beacon Company is considering two different, mutually exclusive capital expendit

Question

Beacon Company is considering two different, mutually exclusive capital expenditure proposals. Project A will cost $492,265, has an expected useful life of 14 years, a salvage value of zero, and is expected to increase net annual cash flows by $74,000. Project B will cost $296,226, has an expected useful life of 14 years, a salvage value of zero, and is expected to increase net annual cash flows by $46,900. A discount rate of 10% is appropriate for both projects. (Refer the below table)

QUESTION: Compute the net present value and profitability index of each project. (If the net present value is negative, use either a negative sign preceding the number eg -45 or parentheses eg (45). Round present value answers to 0 decimal places, e.g. 125 and profitability index answers to 2 decimal places, e.g. 15.25. Round Discount Factor to 5 decimal places, e.g. 0.17986.)

Which project should be accepted?

Net present value - Project A $ Profitability index - Project A Net present value - Project B $ Profitability index - Project B

Explanation / Answer

NPV = {Net Period Cash Flow/(1+R)^T} - Initial Investment

Profitability Index = PV of Future Net Cash Flows / Initial Investment Required

Based on the net present value , Project A should be accepted because of higher cash flows than Project B, however, based on profitability index, project B should be accepted since it has more PI than Project A.

While NPV is a abosulte measure , records time value of money , project with higher NPV should be selected.

Profitability index is a relative measure. Because the incremental investment has a positive NPV, Project A and also for any marginal project , whose NPV is zero , a profitability index (PI) greater than 1 should be accepted.

Hence, Project A should be accepted.

Amt in $ Project A Project B PV of future Cash flows 545135 345498 Less : Initial Investment -492265 -296226 Net Present Value 52870 49272

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