McKnight Company is considering two different, mutually exclusive capital expend
ID: 2499712 • Letter: M
Question
McKnight Company is considering two different, mutually exclusive capital expenditure proposals. Project A will cost $400,000, has an expected useful life of 10 years, a salvage value of zero, and is expected to increase net annual cash flows by $70,000. Project B will cost $310,000, has an expected useful life of 10 years, a salvage value of zero, and is expected to increase net annual cash flows by $55,000. A discount rate of 9% is appropriate for both projects. Click here to view PV table.
Compute the net present value and profitability index of each project. (If the net present value is negative, use either a negative sign preceding the number eg -45 or parentheses eg (45). Round present value answers to 0 decimal places, e.g. 125 and profitability index answers to 2 decimal places, e.g. 15.25. For calculation purposes, use 5 decimal places as displayed in the factor table provided.)
Which project should be accepted based on Net Present Value?
Which project should be accepted based on profitability index?
Explanation / Answer
Calculation of NPV for project A:
Given, present valueof capital expenditure on project A.i.e cash outflows = $400,000 having 10 years useful life
Present values of Annual cash inflows @ 9% discount rate,10 years = $ 70000 * 6.41765 = $ 449,235.50
Net present value = Present values of cash inflows - present value of cash outflows
= 449,235.50 - 400,000
= $ 49,235.50 round off to $ 49,235.00
Profitability index = [Present values of cash inflows]/ Present value of cash outflows
= 449,235/ 400,000 = 1.12
Calculation of NPV for project B:
Given, present value of capital expenditure on project B.i.e cash outflows = $310,000 having 10 years useful life
Present value of cash inflows @9% discount rate for 10 years = $55,000 * 6.41765 = 352,970.75
Net Present value = Present values of cash inflows - present value of cash outflows
= 352,970.75 - 310,000
= 42,970.75 rounf off to $ 42,970
Profitability Index = [Present values of cash inflows]/ Present value of cash outflows
= 352,970/310,000
= 1.13
Therefore,
Net present value of Project A = $ 49,235
Profitability index of project A = 1.12
Net present value of Project B = $ 42,970
Profitability index of project B = 1.13
Conclusion: Based on NPV, Project A should be accepted being higher NPV
Based on profitbility index, Project B should be accepted being higher index.