Question

Oriole Company is considering two different, mutually exclusive capital expenditure proposals. Project A will cost $496,000, has an expected useful life of 12 years and a salvage value of zero, and is expected to increase net annual cash flows by $72,400. Project B will cost $335,000, has an expected useful life of 12 years and a salvage value of zero, and is expected to increase net annual cash flows by $50,000. A discount rate of 8% is appropriate for both projects. Compute the net present value and profitability index of each project.

Answer 1

To compute the net present value (NPV) and profitability index (PI) of each project, we need to discount the net annual cash flows using the appropriate discount rate.

Step-by-step explanation:

To compute the net present value (NPV) of each project, we need to discount the net annual cash flows using the appropriate discount rate. The formula for NPV is:

NPV = Cash Flow / (1 + Discount Rate)Year

For Project A:

NPVA = $72,400 / (1 + 0.08)1 + $72,400 / (1 + 0.08)2 + ... + $72,400 / (1 + 0.08)12 - $496,000

Similarly, for Project B:

NPVB = $50,000 / (1 + 0.08)1 + $50,000 / (1 + 0.08)2 + ... + $50,000 / (1 + 0.08)12 - $335,000

Now, we can use the NPV to calculate the profitability index (PI) of each project:

PI = NPV / Initial Investment

For Project A:

PIA = NPVA / $496,000

For Project B:

PIB = NPVB / $335,000

Answer 2

The net present value of Project A and Project B is calculated by discounting their expected net annual cash flows using an 8% discount rate and subtracting the initial cost. The profitability index is calculated by dividing the present value of cash flows by the initial investment for each project. These calculations aid in determining which project may provide the better investment opportunity.

Step-by-step explanation:

Net Present Value and Profitability Index Calculations for Capital Expenditure Proposals

To calculate the net present value (NPV) of each project, we need to discount the net annual cash flows back to their present value using the given discount rate of 8%.

For Project A, the calculation is as follows:
NPV = ($72,400 / (1 + 0.08)^1) + ($72,400 / (1 + 0.08)^2) + … + ($72,400 / (1 + 0.08)^12) - $496,000

For Project B, the calculation is:
NPV = ($50,000 / (1 + 0.08)^1) + ($50,000 / (1 + 0.08)^2) + … + ($50,000 / (1 + 0.08)^12) - $335,000

The profitability index (PI) is calculated by dividing the present value of future cash flows by the initial investment amount. So, for Project A and Project B, PI formulas would be:
PI (Project A) = Present Value of Cash Flows for Project A / $496,000
PI (Project B) = Present Value of Cash Flows for Project B / $335,000

We use a financial calculator or present value tables to find the present value of an annuity. After getting the present values for each project, we subtract the initial investment to get the NPV and divide by the initial investment to get the PI.

By comparing the NPV and PI of both projects, Oriole Company can make an informed decision on which project to undertake based on the higher NPV or PI, as these are indicators of expected profitability and return on investment.