Question

Charles-Baker, International, Inc is investing in two projects, You must assist them in choosing the “correct alternative” for each scenario. They have two projects. A and B. Project A has an initial cost (now) -$16,000 and yearend returns of $10,500, $9,100 and $3,000 respectively for years 1, 2, and 3. Project B has an initial cost of -$3,200 and yearend returns of $3,300, $1,260 and $600 respectively for years 1, 2, and 3.

a. Assist Charles-Baker, International, Inc. in determining which project they are to select by computing the net present value (NPV) and profitability index (PI) for both projects assuming a 10 percent discount rate.

b. Which of the Projects is better according to each of the two methods?

c. What is your explanation for the differences in ranking between NPV and PI methods of analysis?

d. Which method is correct? Why?

Answer 1

1.
NPV
Project A=-16000+10500/1.1+9100/1.1^2+3000/1.1^3=3320.0601052

Project B=-3200+3300/1.1+1260/1.1^2+600/1.1^3=1292.1111946

PI
Project A=1+3320.0601052/16000=1.2075038

Project B=1+1292.1111946/3200=1.4037847

2.
NPV method: Project A is better

PI method: Project B is better

3.
Difference is size of projects

4.
NPV method is correct as it measures the amount of value added, which is consistent with shareholder wealth maximization and also there is no capital rationing