Question

Vista Company is consideringt two new projects, each requiring an equipment investment of $97,000. Each project will last for three years and produce the following cash inflows:
Year Cool Hot
1 $38,000 $42,000
2 43,000 42,000
3 48,000 42,000
129,000 $126,000

The equipment will have no salvage value at the end of its three-year life. Vista Company uses straight-line depreciation and requires a minimum rate of return of 12%.

Present Value of 1 Present Value of an Annuity of 1

Period 12% Period 12%
1 0.893 1 0.893
2 0.797 2 1.690
3 0.712 3 2.402

Required:
a. Compute the net present value of each project.
b. Compute the profitability index of each project.
c. Which project should be selected? Why?

Answer 1

Answer:

a. Net Present Value of Cool:

= Present value of cash inflows - Initial investment

= ∑(Cash flows * Present value factor) - Initial investment

= (38,000 * 0.893) + (43,000 * 0.797) + (48,000 * 0.712) - 97,000

= 102,381 - 97,000

= $5,381

Net Present value of Hot.

Cashflows are constant so this is an annuity:

= Cashflow * Present value interest factor of annuity - Initial investment

= 42,000 * 2.402 - 97,000

= 100,884 - 97,000

= $3,884

b. Profitability index for Cool:

= Present value of inflows / Initial investment

= 102,381 / 97,000

= 1.06

Profitability index for Hot:

= 100,884 / 97,000

= 1.04

c. Project Cool should be selected because it has a higher Net Present Value.