Using payback, NPV, and profitability index to make capital investment decisions
ID: 2580050 • Letter: U
Question
Using payback, NPV, and profitability index to make capital investment decisions Splash City is considering purchasing a water park in Omaha, Nebraska, for $1,910,000. The new facility will generate annual net cash inflows of $487,000 for eight years. Engineers estimate that the facility will remain useful for eight years and have no residual value. The company uses straight-line depreciation, and its stockholders demand an annual return of 10% on investments of this nature. Requirements 1.) Compute the payback, the NPV, and the profitability index of this investment. 2.) Recommend whether the company should invest in this project. Using payback, NPV, and profitability index to make capital investment decisions Splash City is considering purchasing a water park in Omaha, Nebraska, for $1,910,000. The new facility will generate annual net cash inflows of $487,000 for eight years. Engineers estimate that the facility will remain useful for eight years and have no residual value. The company uses straight-line depreciation, and its stockholders demand an annual return of 10% on investments of this nature. Requirements 1.) Compute the payback, the NPV, and the profitability index of this investment. 2.) Recommend whether the company should invest in this project.Explanation / Answer
1) Investment = $1,910,000
Annual net cash inflow = $487,000
Payback period = Investment ÷ Annual net cash inflow = 1,910,000÷487,000 = 3.92 years
Present value = Annual net cash inflow × PVIFA of $1 (10%, 8) = 487,000×5.3349 = $2,598,096
NPV = Present value - Investment = 2,598,096-1,910,000 = $688,096
Profitability index = Present value ÷ Investment = 2,598,096÷1,910,000 = 1.36
2) The NPV of the investment is positive and profitability index is more than 1, which represent that the investment is profitable and hence it should be accepted.
The company should invest in this project.
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