Al a Mode, Inc., is considering one of two investment options. Option 1 is a $46
ID: 2454370 • Letter: A
Question
Al a Mode, Inc., is considering one of two investment options. Option 1 is a $46,000 investment in new blending equipment that is expected to produce equal annual cash flows of $13,000 for each of seven years. Option 2 is a $50,000 investment in a new computer system that is expected to produce equal annual cash flows of $17,000 for each of five years. The residual value of the blending equipment at the end of the fifth year is estimated to be $9,000. The computer system has no expected residual value at the end of the fifth year.
Assume there is sufficient capital to fund only one of the projects. Determine which project should be selected, comparing the (a) net present values and (b) present value indices of the two projects, assuming a minimum rate of return of 10%. Use the present value tables appearing above.
a. Determine the net present values of the two projects.
b. Determine the present value indices of the two projects. If required, round the present value index to two decimal places.
Which project should be selected? (If both present value indices are the same, either project will grade as correct.)
Present Value of $1 at Compound Interest Year 6% 10% 12% 15% 20% 1 0.943 0.909 0.893 0.870 0.833 2 0.890 0.826 0.797 0.756 0.694 3 0.840 0.751 0.712 0.658 0.579 4 0.792 0.683 0.636 0.572 0.482 5 0.747 0.621 0.567 0.497 0.402 6 0.705 0.564 0.507 0.432 0.335 7 0.665 0.513 0.452 0.376 0.279 8 0.627 0.467 0.404 0.327 0.233 9 0.592 0.424 0.361 0.284 0.194 10 0.558 0.386 0.322 0.247 0.162Explanation / Answer
a.) NPV = P.V. of Cash inflow - P.V. of Cash outflow
Blending Equipment:-
Present value of cash inflow:-
Cumulative Present value factor @ 10% for Seven years = 4.868
Present value of cash inflow = 13000 * 4.868
Present value of cash inflow = 63284 (x)
Present value of Salvage value of Blending equipment = 9000 * 0.621(NOTE 1)
= 5589 (y)
Total Present value of Cash inflow = (x) + (y) = 63284 + 5589 = 68873
(NOTE 1) :- The residual value of the blending equipment at the end of the fifth year is estimated to be $9,000. So the Present value factor of Fifth year is to be used.
P.V of Cash Outflow = 46000
Net Present value (NPV) = 68873 - 46000 = 22873
Computer System:-
Present value of cash inflow:-
Cumulative Present value factor @ 10% for Five years = 3.791
Present value of cash inflow = 17000 * 3.791
Present value of cash inflow = 64447
Total Present value of Cash inflow = 64447
P.V of Cash Outflow = 50000
Net Present value (NPV) = 64447 - 50000 = 14447
b.) Present value indices:- P.V. of Cash inflow / P.V. of cash outflow
Blending equipment = 68873 / 46000 = 1.50 (approx)
Computer system = 64447 /50000 = 1.29 (approx)
Blending Equipment is to be selected as the Present value indices of Blending equpiment is higher than the Present value indices of computer system.
Conclusion:-
a. NPV 1) Blending equpiment
2) Computer system
$ 22873
$ 14447
b. Present value indices 1) Blending equpiment
2) Computer system
1.50
1.29
Blending Equipment is to be selected as the Present value indices of Blending equpiment is higher than the Present value indices of computer system.
a. NPV 1) Blending equpiment
2) Computer system
$ 22873
$ 14447
b. Present value indices 1) Blending equpiment
2) Computer system
1.50
1.29
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