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McKnight Company is considering two different, mutually exclusive capital expenditure proposals....

Question:

McKnight Company is considering two different, mutually exclusive capital expenditure proposals. Project A will cost $523,048, has an expected useful life of 12 years, a salvage value of zero, and is expected to increase net annual cash flows by $72,100. Project B will cost $357,512, has an expected useful life of 12 years, a salvage value of zero, and is expected to increase net annual cash flows by $50,400. A discount rate of 7% is appropriate for both projects.

Required:

1. Compute the net present value and profitability index of each project.

2. Which project should be accepted based on Net Present Value?

3. Which project should be accepted based on profitability index?

Net present value and Profitability Index:

The net present value method and the profitability index method, both are the tools used by the organization for investment decision making. The net present value can be evaluated after detecting the present value of cash outflow from the present value of cash inflow and profitability index can be calculated by dividing the present value of cash inflow with the initial investment.

Answer and Explanation:

Answer A1

Project A

NPV = Present value of all cash inflows ? Present value of cash outflows

According to the question

Project cost will be $523,048

And outflows will be $72100 in year 12 years

So, the present value of 12 year's cash inflow = $72,100 x 7.942686 = 572,667.68

So, NPV = 572,667.68 - 523,048 = 49,619.68

Project A

NPV = Present value of all cash inflows ? Present value of cash outflows

According to the question

Project cost will be $357,512

And outflows will be $50,400 in year 12 years

So, the present value of 12 year's cash inflow = $50,400 x 7.942686 =400311.374

So NPV = 400,311.37 - 357,512 = 42,799.37

Answer A2

Profitability index

{eq}\textrm{Profitability Index} = \dfrac{\textrm{Present value of cash inflow}}{\textrm{Initial investment}} {/eq}

Project A

{eq}\textrm{Profitability Index} = \dfrac{\textrm{49,619.68}}{\textrm{523,048}} = 0.09486 {/eq}

Project B

{eq}\textrm{Profitability Index} = \dfrac{\textrm{ 42,799.37}}{\textrm{357,512}} = 0.09486 {/eq}

Answer B

As the net present value of project A is 6820.31( 49,619.68 - 42,799.37) higher, so the project A should be accepted on the basis of the net present value method.

Answer C

As Per the profitability index method, both of the projects have the same profitability index i.e 0.09486. So any of both of them can be chosen, on the basis of the profitability index method.


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