Leslie is charged with determining which small projects should be funded. Along
ID: 2769113 • Letter: L
Question
Leslie is charged with determining which small projects should be funded. Along with this assignment, she has been granted the use of $15,000 for a maximum of two years. She is considering three projects. Project A costs $7,500 and has cash flows of $4,000 a year for Years 1 to 3. Project B costs $8,000 and has cash flows of $3,000, $4,000, and $3,000 for Years 1 to 3, respectively. Project C costs $2,000 and has a cash inflow of $2,500 in Year 2. What decisions should she make regarding these projects if she assigns them a mandatory discount rate of 8.5 percent? Explain why. Answer options:
1. accept either Projects A and C or Projects B and C, but not all three as there is insufficient financing
2. accept Project C and reject Projects A and B because only Project C has a discounted payback that is less than two years
3. accept Projects A and C and reject Project B as they have the shortest discounted payback periods than fit within the $15,000 allocation
4. accept Projects A and C and reject Project B as A and B payback within two years
5. accept Projects B and C and reject Project A as this combination uses the most initial capital
Explanation / Answer
We need to compute profitability index of each project.
Project A
year
Cash flow
PV factor 8.50%
PV
1
4000
0.9217
3686.636
2
4000
0.8495
3397.821
3
4000
0.7829
3131.632
10216.09
Profitability Index = PV of cash inflows / Initial Investment
= 10216.09/7500
= 1.36
Project B
year
Cash flow
PV factor 8.50%
PV
1
3000
0.9217
2764.977
2
4000
0.8495
3397.821
3
3000
0.7829
2348.724
8511.522
Profitability Index = PV of cash inflows / Initial Investment
= 8511.522/8000
= 1.064
Project C
year
Cash flow
PV factor 8.50%
PV
1
0
0.9217
0
2
2500
0.8495
2123.638
3
0
0.7829
0
2123.638
Profitability Index = PV of cash inflows / Initial Investment
= 2123.638/2000
= 1.062
We can rank the projects based on their profitability index as follows:
-Project A
-Project B
- Project C
Project A requires 7500 and project B requires 8000 and we have a budget of 15000. So both projects A and B cannot selected at the same time. Therefore, we will choose project A and Project C from the given budget.
The second alternative can be choosing projects B and C.
Therefore, option 1 is correct.
year
Cash flow
PV factor 8.50%
PV
1
4000
0.9217
3686.636
2
4000
0.8495
3397.821
3
4000
0.7829
3131.632
10216.09
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