Question

The Dark Blue Furniture Company is considering two mutually exclusive expansion projects. Project X will cost $20,000 to implement, and will generate $10,000 each year in positive net, after-tax cash flows for the next 3 years. Project Y will cost $3,000 to implement, and will generate $2,500 in net, after-tax cash flows for the next 3 years. The firm’s WACC is 9%.

a. Calculate the net present value of each project. Which is preferable by the NPV method?

b. Calculate the profitability index of each project. Which is preferable by the PI method?

c. Explain the source of any conflicts in your analysis.

d. Provide a clear, unambiguous recommendation to management and justify your decision.

Answer 1

NPV of Project X=-20000+10000/1.09+10000/1.09^2+10000/1.09^3=5312.9466

NPV of Project Y=-3000+2500/1.09+2500/1.09^2+2500/1.09^3=3328.23666

Higher NPV project that is Project X is chosen

Profitability Index=1+NPV/Initial Investment

PI of Project X=1+5312.9466/20000=1.26564733

PI of Project Y=1+3328.2366/3000=2.109

Higher PI that is Project Y is chosen

Due to different scale of investment, they are giving different recommendations

NPV method should be preferred that is choose Project X because the objective is to maximize shareholder's wealth and project with largest NPV is adding more absolute value to the firm