Problem 2. Delta Company is evaluating two different capital investments, Projec

Question

Problem 2. Delta Company is evaluating two different capital investments, Project X and Y. Either X or Y would cost $100,000, and the company cannot afford to do both. The company expects that Project X would provide net cash inflows of $30,000 per year for 5 years. For Project Y, the net cash inflows are expected to be as follows:

YEAR

CASH INFLOWS FROM PROJECT Y

1

22,000

2

24,000

3

30,000

4

38,000

5

40,000

Delta's cost of capital is 12%

Required:

1) Calculate the present value index for Project X and for Project Y.
2) Indicate whether each of the projects is an acceptable investment.
3) Which of the two projects should Delta implement?

YEAR

CASH INFLOWS FROM PROJECT Y

1

22,000

2

24,000

3

30,000

4

38,000

5

40,000

Explanation / Answer

Solution:

Present Value Index is the technique of Capital Budgeting to evaluate the project investment.

Present Value Index is the ratio of Present Value of Expected Cash Inflows to Present Value of Expected Cash Outflows or Initial Investment

Selection Criteria based on Present Value Index

If Present Value Index is greater than or equals to 1 ----- Project is Accepted

If Present Value Index is lesser than 1 ----- Project is Rejected

Part 1 – Calculation of Present Value Index

Step 1 --- Calculate the Present Value of Expected Cash Inflows

Step 2 – Find out the Present Value of Cash Outflow or Initial Investment

Step 3 – Calculate Present Value Index (Step 1 / Step 2)

Year

PV factor @ 12%

Project X

Project Y

Annual Expected Cash Inflows

Present Value of Cash Inflows

Annual Expected Cash Inflows

Present Value of Cash Inflows

(A)

(B)

(A*B)

(P)

(A*B)

1

0.893

$30,000

$26,786

$22,000

$19,643

2

0.797

$30,000

$23,916

$24,000

$19,133

3

0.712

$30,000

$21,353

$30,000

$21,353

4

0.636

$30,000

$19,066

$38,000

$24,150

5

0.567

$30,000

$17,023

$40,000

$22,697

Present Value of Cash Inflows

$108,143

$106,976

Present Value of Cash Outflow (i.e. Initial Investment)

$100,000

$100,000

Present Value Index (Present Value of Cash Inflows / Present Value of Cash Outflows)

1.08

1.07

Present Value Index for Project X = 1.08

Present Value Index for Project Y = 1.07

Part 2 – Yes, each of the projects is an acceptable investment. Since the Present Value Index of both the projects is greater than 1.

Part 3 – Delta should implement Project X. Since Project X has higher Present Value Index than Project Y.

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Year

PV factor @ 12%

Project X

Project Y

Annual Expected Cash Inflows

Present Value of Cash Inflows

Annual Expected Cash Inflows

Present Value of Cash Inflows

(A)

(B)

(A*B)

(P)

(A*B)

1

0.893

$30,000

$26,786

$22,000

$19,643

2

0.797

$30,000

$23,916

$24,000

$19,133

3

0.712

$30,000

$21,353

$30,000

$21,353

4

0.636

$30,000

$19,066

$38,000

$24,150

5

0.567

$30,000

$17,023

$40,000

$22,697

Present Value of Cash Inflows

$108,143

$106,976

Present Value of Cash Outflow (i.e. Initial Investment)

$100,000

$100,000

Present Value Index (Present Value of Cash Inflows / Present Value of Cash Outflows)

1.08

1.07

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