Question

Following is information on two alternative investments being considered by Tiger Co. The company requires a 7% return from its investments. (PV of $1, FV of $1, PVA of $1, and FVA of $1) (Use appropriate factor(s) from the tables provided.)

	Project X1					Project X2
Initial investment		$	(106,000	)			$	(172,000	)
Expected net cash flows in:
Year 1			38,000					79,500
Year 2			48,500					69,500
Year 3			73,500					59,500

a. Compute each project’s net present value.
b. Compute each project’s profitability index. If the company can choose only one project, which should it choose?

Answer 1

a) You can calculate the Net Present Value in the following way:

	Project X1	PVF of 7%	Present Value		Project X2	PVF of 7%	Present Value
Initial investment	$       -1,06,000	1	$       -1,06,000		$       -1,72,000	1	$       -1,72,000
Expected net cash flows in:
Year 1	$             38,000	0.93458	$             35,514		$             79,500	0.93458	$             74,299
Year 2	$             48,500	0.87344	$             42,362		$             69,500	0.8734	$             60,701
Year 3	$             73,500	0.8163	$             59,998		$             59,500	0.8163	$             48,570
Net Present Value			$             31,874				$             11,570

b) Profitability Index

	Project X1		Project X2
	Present Value		Present Value
Year 1	$             35,514		$             74,299
Year 2	$             42,362		$             60,701
Year 3	$             59,998		$             48,570
Present Value of Inflows	$         1,37,874		$         1,83,570
Initial investment	$         1,06,000		$         1,72,000
Profitability Index	1.30		1.07

If we need to choose one of the two projects for capital budgeting, Project X1 should be pursued since it had higher NPV and higher Profitability index compared to project X2.

Notes

1) To derive the Net Present Value or NPV, you need to follow the following steps:

- Multiply the cash inflows & outflows by the present value factor

- Sum the present values

2) Profitability index is calculated by

- Summing up the present value of inflows

- Divide the above number by Initial investment