Al a Mode, Inc., is considering one of two investment options. Option 1 is a $47

Question

Al a Mode, Inc., is considering one of two investment options. Option 1 is a $47,000 investment in new blending equipment that is expected to produce equal annual cash flows of $15,000 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 $19,000 for each of five years. The residual value of the blending equipment at the end of the fifth year is estimated to be $10,000. The computer system has no expected residual value at the end of the fifth year. Present Value of $1 at Compound Interest 10% 20% 0.833 0.694 0.579 0.482 0.747 0.621 0.567 0.4970.402 0.335 0.279 0.627 0.467 0.404 0.327 0.233 0.194 0.558 0.386 0.322 0.247 0.162 15% .943 909 0.893 0.870 0.890 0.826 0.7970.756 0.840 0.751 0.712 0.658 0.572 Year 696 12% 4 0.792 0.683 0.636 0.705 0.564 0.507 0.432 7 0.665 0.513 0.452 0.376 0.592 0.424 0.361 0.284 10

Explanation / Answer

Present Value of Equal Cash Flows = Cash-inflow each year * Annuity factor

NPV = Present Value of Equal Cash In-flows – Initial Investment

Present Value Index = PV of Cash inflows / Initial Investment

Option 1:

Initial Investment = $47,000
Annual Cash flow = $15,000
Annuity Factor (12%, 7 Years) = 4.564

Present Value of Cash flows = $15,000*4.564 = $68,460

NPV = $68,460 - $47,000 = $21,460

Present Value Index = $68,460/$47,000 = 1.46

Option 2:

Initial Investment = $50,000
Annual Cash flow = $19,000
Annuity Factor (12%, 5 Years) = 3.605

Present Value of Cash flows = $19,000*3.605 = $68,495

NPV = $68,495 - $50,000 = $18,495

Present Value Index = $68,495/$50,000 = 1.37

Since the Present Value Index for Option 1 is higher, the company should invest in Blending Equipment.

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