Question

Ranger Corporation has decided to invest in renewable energy sources to meet part of its energy needs for production. It is considering solar power versus wind power. After considering cost savings as well as incremental revenues from selling excess electricity into the power grid, it has determined the following.
Solar Wind
Present value of annual cash flows $52,580 $128,450
Initial investment $39,500 $105,300

Required:
Determine the net present value and profitability index of each project. Which energy source should it choose?

Answer 1

Answer:

Net present value of Solar = $13,080

Net present value of Wind = $23,150

Profitability index of Solar  = 1.33

Profitability index of Wind = 1.22

Ranger Corporation should choose Solar.

Explanation:

Net present value (NPV) refers to the difference between the present value of cash flows and initial investment of a project. It can be calculated as follows:

Net present value = Present value of annual cash flows - Initial investment ...... (1)

Profitability index refers to the ratio of the present value of cash flows to the initial investment of a project. It shows the amount of returns in present value for every one dollar invested. It can be calculated as follows:

Profitability index = Present value of annual cash flows / Initial investment ...... (2)

Using equation (1) and (2), we have:

Net present value of Solar = $52,580 - $39,500 = $13,080

Net present value of Wind = $128,450 - $105,300 = $23,150

Profitability index of Solar = $52,580 / $39,500 = 1.33

Profitability index of Wind = $128,450 / $105,300 = 1.22

Ranger Corporation should choose Solar. This is because despite that its NPV of $13,080 is lower than $23,150 of Wind, its Profitability index of 1.33 is higher. This indicates that the amount of returns in present value for every one dollar invested in Solar is higher than that of Wind.