Company A has the opportunity to do any, none, or all of the projects for which

Question

Company A has the opportunity to do any, none, or all of the projects for which the net cash flows per year are shown below. Projects A and C can be done together. Projects B and C can be done together. But Projects A and B are mutually exclusive. The company has a cost of capital of 18%. Which should the company do and why? You must use at least two capital budgeting methods. Show your work.

A B C 0 -500 -500 -600 1 200 -200 100 2 200 600 100 3 200 400 100 4 200 200 100 5 200 -300 100 6 200    100 7 -300    100

Explanation / Answer

Step1: Computation of Present Value of project A, B & C.We have,

Step2; Computation of Net Present Value (NPV) of project A,B&C.We have,

Net Present Value is found by subtracting a projcts initial investment from the present value of its cash inflows discounted at the firm's cost of capitals. If Net Present Value of project is positive value.Then, it is acceptable otherwise project is rejected.The formula of Net Present Value is:

Net Present Value (NPV) = Present value of cash inflow - Present value of cash outflow

NPVA = 605.20 - 500 =   $ 105.20

NPVB = 477.10 - 500 = - $ 22.90

NPVC = 381.10 - 600 = - $ 218.90

Step3: Computation of profitability Index (PI) of project A,B & C.We have,

Profitability Index measures the present value of returns per rupee invested.If profitablity index is come more than 1.Then, it is worthwhile and acceptable otherwise it is rejected.The formula of profitability index is

   Profitablity Index (PI) = Present Value of cash inflow / Present value of cash outflows

   PIA = 605.20 / 500 = 1.21

   PIB = 477.10 / 500 = 0.95

   PIC = 381.10 / 600 = 0.63

Conclusion: As per the both technique of Capital Budgeting( Net present value technique and profitablity index technique), Only Project A should be worthwhile for the company.It is because project A have NPV $ 105.20 and PI is 1.21. Other project B & C have negative NPV (- $ 22.90 & - $ 218.90) and lower than 1 PI (0.95 & 0.63).Therefore, Project A should be accepted and Project B & C should be rejected.

Periods Cash flow of project A Cash flow of project B Cash flow of Projct C PVIF@18% Present Value of cash flow of project A Present Value of cash flow of project B Present Value of cash flow of project C 1 200 -200 100 0.847 169.40 -169.40 84.70 2 200 600 100 0.718 143.60 430.80 71.80 3 200 400 100 0.609 121.80 243.60 60.90 4 200 200 100 0.516 103.20 103.20 51.60 5 200 -300 100 0.437 87.40 -131.10 43.70 6 200 100 0.370 74.00 37.00 7 -300 100 0.314 -94.20 31.40 605.20 477.10 381.10

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