Question

A firm is considering two capital investment projects. Project A involves an initial cost of $15,000. The discounted present value of all future cash flows is $18,000. Project B requires an initial expenditure of $25,000. The discounted present value of all future cash flows is $29,000.

(i)	Calculate the net present value of each of the two projects. Which would be preferred according to the net present value criterion?

(ii)	Calculate the profitability index of each of the two projects. Which would be preferred according to the profitability index criterion?

Answer 1

(i) Net present value (NPV) = Initial cost - Discounted present value of future cash flows

NPV, Project A ($) = - 15,000 + 18,000 = 3,000

NPV, Project B ($) = - 25,000 + 29,000 = 4,000

Since Project B has higher NPV, this should be selected.

(ii) Profitability index (PI) = Discounted present value of future cash flows / Initial cost

PI, Project A = 18,000 / 15,000 = 1.20

PI, Project B = 29,000 / 25,000 = 1.16

Since Project B has higher PI, this should be selected.