Stephens Industries is contemplating four projects: Project P, Project Q, Projec

Question

Stephens Industries is contemplating four projects: Project P, Project Q, Project R, and Project S. The capital costs and estimated after-tax net cash flows of each project are shown in the table that follows. Stephens’s after-tax cost of capital is 12 percent. Excess funds cannot be reinvested at greater than 12 percent.

Project P          Project Q         Project R         Project S

Initial cost $200,000         $235,000         $190,000         $210,000

Annual cash flows:

Year 1 93,000 90,000 45,000 40,000

Year 2 93,000 85,000 55,000 50,000

Year 3 93,000 75,000 65,000 60,000

Year 4 0                     55,000 70,000 65,000

Year 5 0 50,000 75,000 75,000

NPV              $23,370 $29,827 $27,233 $(7,854)

Internal rate 18.7% 17.6% 17.2% 10.6%

Of return

Profitability 1.12 1.13 1.14 0.95

index

Required

A. Which of the four projects are acceptable options? Why?

B. If only one project can be accepted, which one should the company choose?

Explanation / Answer

Answer A.

Out of four projects P, Q, R, & S only Project P, Project Q and Project R are the acceptable options.

Reason: Project P, Q and R have positive NPV of 23370, 29827 and 27233 respectively. Considering Profitability index all three have PI more than 1. Moreover considering the cost of capital 12% and IRR for all three projects P,Q,R i.e. 18.7% , 17.6% &17.2% respectively all three projects are acceptable options because investors of Stephens Industries would be able to earn more than their cost of capital.

Answer B.

If one of the project could be selected then Stephens Industries should go for Project Q.

Though IRR method is considered more appropriate in investing decisions however in the present case the NPV method seems to be most appropriate for choosing one amongst these projects. This is because of the reason that excess funds cannot be invested anywhere more than 12%. So Project Q gives highest NPV along with IRR more than company’s cost of capital where all available funds will be optimally utilized. If company would go for Project P considering highest IRR then there will be funds which will have to be invested at a lower rate of 12%. Hence Project Q should be accepted.

Related Questions

Navigate

• Browse (All)
• Browse S
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.