Alfarsi Industries uses the net present value method to make investment decision

Question

Alfarsi Industries uses the net present value method to make investment decisions and requires a 15% annual return on all investments. The company is considering two different investments. Each require an initial investment of $15,000 and will produce cash flows as follows: End of Year Investment A B 1 $8,000 $0 2 8,000 0 3 8,000 24,000 The present value factors of $1 each year at 15% are: 1 0.8696 2 0.7561 3 0.6575 The present value of an annuity of $1 for 3 years at 15% is 2.2832 Which investment should Alfarsi choose?

Explanation / Answer

Answer: NPV is calculated by subtracting the initial investment from the PV of cash inflows over a period of time.

Investment A:

NPV = -15000 + 8000 *PVIFA (15%,3)

NPV = -15000 + 8000* 2.2832

NPV = -15000+18265.6 = $3265.6

Investment B:

NPV = -15000 + 0*PVIF(15%,1) + 0*PVIF (15%,2) + 24000*PVIF (15%,3)

NPV = -15000 + 0 +0 + 24000*0.6575

NPV = -15000 + 15780

NPV = $780

Alfarsi should choose investment A as NPV of investment A is higher than NPV of investment B.

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