Question

Following is information on two alternative investments being considered by Tiger Co. The company requires a 4% return from its investments.

Project X1 Project X2

Initial investment . . . . . . . . . . . . . . . . . . . . . . . . . \((80,000) \)(120,000)

Expected net cash flows in year:

1........................ 25,000 60,000

2........................ 35,500 50,000

3........................ 60,500 40,000

Compute each project’s (a) net present value and

(b) profitability index. (Round present value calculations to the nearest dollar and round the profitability index to two decimal places.) If the company can choose only one project, which should it choose? Explain.

Short answer

The present value of project A is $30,645, project B is $19,480 and the profitability index of project A is 1.38, and project B is 1.16

Step-by-step solution

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

Net present value of project X1

Initial Investment = $80,000, I = 4%
Year	Cash Inflow	x	PV Factor	=	Present Value
1	$25,000	X	0.9615	=	$24,038
2	35,500	X	0.9246	=	32,823
3	$60,500	X	0.8890	=	53,785
					110,645
Present value of cash inflows					110,645
Present Value of cash outflows					-80,000
Net Present Value					$30,645

Net present value of project X2

Initial Investment = $120,000, I = 4%
Year	Cash Inflow	x	PV Factor	=	Present Value
1	$60,000	X	0.9615	=	$57,690
2	50,000	X	0.9246	=	46,230
3	$40,000	X	0.8890	=	35,560
					139,480
Present value of cash inflows					139,480
Present Value of cash outflows					-120,000
Net Present Value					$19,480

Computation of profitability index

Project X1

$$\begin{gathered} \mathbf{Profitability}\mathbf{}\mathbf{}\mathbf{Index}\mathbf{=}\frac{\mathrm{Present}\mathrm{Value}\mathrm{of}\mathrm{net}\mathrm{cash}\mathrm{flows}}{\mathrm{Initial}\mathrm{Investment}} \\ \mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{=}\frac{\$110,645}{\$80,000} \\ \mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{=}\mathbf{1}\mathbf{.}\mathbf{38} \end{gathered}$$

Project X2

$$\begin{gathered} \mathbf{Profitability}\mathbf{}\mathbf{Index}\mathbf{=}\frac{\mathrm{Present}\mathrm{Value}\mathrm{of}\mathrm{net}\mathrm{cash}\mathrm{flows}}{\mathrm{Initial}\mathrm{Investment}} \\ \mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{=}\frac{\$139,480}{\$120,000} \\ \mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{=}\mathbf{1}\mathbf{.}\mathbf{16} \end{gathered}$$