Midtown Shopping Center is trying to decide between the following two investment
ID: 2497997 • Letter: M
Question
Midtown Shopping Center is trying to decide between the following two investments:
Equipment #1 Equipment #2
Initial outlay $5,000 Initial outlay $8,000
Annual cash inflow $1,800 Annual cash inflow $2,900
Estimated useful life 4 years Estimated useful life 4 years
Residual value $ 500 Residual value $ 200
Assume the cost of capital is 12%.
Required:
Calculate the NPV and profitability index for each equipment. Based on your calculations, which equipment should they purchase?
Explanation / Answer
Equipment 1
NPV = P.V. of cash inflow - P.V. of cash outflow
P.V. of cash inflow: = 1800 * Cumulative P.V Factor @ 12 % for 4 Years + 500 * P.V. Factor @ 12% for 4TH Year
= 1800 * 3.037 + 500 * 0.636 (approx)
= 5784.6 i.e., $ 5785 (approx)
NPV = 5785 - 5000 = $ 785
Profitability index (PI) = P.V. of cash inflow / P.V. of cash outflow
= 5785 / 5000
= 1.157
Equipment 2
NPV = P.V. of cash inflow - P.V. of cash outflow
P.V. of cash inflow:= 2900 * Cumulative P.V Factor @ 12 % for 4 Years + 200 * P.V. Factor @ 12% for 4TH Year
= 2900 * 3.037 + 200 * 0.636 (approx)
= 8934.5 i.e., $ 8935 (approx)
NPV = 8935 - 8000 = $ 935
Profitability index (PI) = P.V. of cash inflow / P.V. of cash outflow
= 8935 / 8000
= 1.117 (approx)
Conclusion:-
The Decision is taken on the basis of NPV. As the NPV of equipment 2 is greater than equipment 1, Therefore, the Equipment 2 should be purchased.
Equipment 1 Equipment 2 NPV $ 785 $ 935 Profitability index 1.157 1.117