Question

Following is information on two alternative investments being considered by Jolee Company. The company requires a 10% return from its investments.

Project A Project B

Initial investment . . . . . . . . . . . . . . . . . . . . . . . . . \((160,000) \)(105,000)

Expected net cash flows in year:

1........................ 40,000 32,000

2........................ 56,000 50,000

3........................ 80,295 66,000

4........................ 90,400 72,000

5........................ 65,000 24,000

For each alternative project, compute the

(a) net present value and

(b) profitability index. (Round your answers in part b to two decimal places.) If the company can only select one project, which should it choose? Explain.

Short answer

The present value of project A is $85,070, project B is $79,075 and the profitability index of project A is 1.5317, and project B is 1.7531

Step-by-step solution

Step-by-Step SolutionStep 1: Computation of net present value

Net present value of project A

Initial Investment = $160,000, I = 10%
Year	Cash Inflow	x	PV Factor	=	Present Value
1	$40,000	X	0.9091	=	$33,364
2	56,000	X	0.8264	=	46,278
3	80,295	X	0.7513	=	60,326
4	90,400	X	0.6830	=	61,743
5	$65,000	X	0.6209	=	40,359
					245,070
Present value of cash inflows					245,070
Present Value of cash outflows					-160,000
Net Present Value					$85,070

Net present value of project B

Initial Investment = $105,000, I = 10%
Year	Cash Inflow	x	PV Factor	=	Present Value
1	$32,000	X	0.9091	=	$29,091
2	50,000	X	0.8264	=	41,320
3	66,000	X	0.7513	=	49,586
4	72,000	X	0.6830	=	49,176
5	$24,000	X	0.6209	=	14,902
					184,075
Present value of cash inflows					184,075
Present Value of cash outflows					-105,000
Net Present Value					$79,075

Computation of profitability index

Project A

$$\begin{gathered} \mathbf{Profitability}\mathbf{}\mathbf{Index}\mathbf{=}\frac{\mathrm{Present}\mathrm{Value}\mathrm{of}\mathrm{net}\mathrm{cashflows}}{\mathrm{Initial}\mathrm{Investment}} \\ \mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{=}\frac{\$245,070}{\$160,000} \\ \mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{=}\mathbf{1}\mathbf{.}\mathbf{5317} \end{gathered}$$

Project B

$$\begin{gathered} \mathbf{Profitability}\mathbf{}\mathbf{Index}\mathbf{=}\frac{\mathrm{Present}\mathrm{Value}\mathrm{of}\mathrm{net}\mathrm{cashflows}}{\mathrm{Initial}\mathrm{Investment}} \\ \mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{=}\frac{\$184,075}{\$105,000} \\ \mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{=}\mathbf{1}\mathbf{.}\mathbf{7531} \end{gathered}$$