The Safa Corporation is considering purchasing one of two new equipment for the

Question

The Safa Corporation is considering purchasing one of two new equipment for the upcoming year. The more expensive of the two is better and will produce a higher yield. Assume these projects are mutually exclusive and that the required rate of return is 10 percent. Given the following free cash flows: PROJECT B -$5,000 6,000 PROJECTA Initial outlay Inflow year 1 -$500 700 a. Calculate the NPV of each project. b. Calculate the Pl of each project. c. If there is no capital-rationing constraint, which project should be selected? If there is a capital rationing constraint, how should the decision be made?

Explanation / Answer

(a). NPV of the projects;

For project A;

Initial outlay for the project = $500

Present value of inflow ($700 / 1.10) = $636.36

Thus NPV of this project will be ($636.36 – $500) = $136.36

For project B;

Initial outlay for the project = $5000

Present value of inflow ($6000 / 1.10) = $5454.54

Thus NPV of this project will be ($5454.54 – $5000) = $454.54

(b). PI of the projects;

Formula of PI = (Present value future cash flow / Initial investment)

For project A;

Initial investment = $500

Present value of future cash flow = $636.36

PI = $636.36 / $500 = 1.27

For project B;

Initial investment = $5000

Present value of future cash flow = $5454.54

PI = $5454.54 / $5000 = 1.09

(c).

If there is no capital-rationing constrain then both project should be accepted because both project have positive NPV and PI is also more than 1.

If there is capital-rationing constrain then Project-A should be accepted because Project-A have positive NPV and PI is also higher than PI of Project-B.

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