Question

Expected Cash Flows

Year Project A Project B

0 -500 -875

1 100 150

2 110 200

3 120 252

4 175 375

5 240 530

6 300 680

a. If you were told that each project’s cost of capital was 12%, which project should be selected using the NPV criteria?

b. What is the profitability index for each project if the cost of capital is 12%?

c. What is the regular payback period for these two projects?

Answer 1

a. If you were told that each project’s cost of capital was 12%, then:

$NPVa = -500 + 100/1.12 + 110/1.12^2 + 120/1.12^3 + 175/1.12^4 + 240/1.12^5 + 300/1.12^6 = 161.78.$

$NPVb = -875 + 150/1.12 + 200/1.12^2 + 252/1.12^3 + 375/1.12^4 + 530/1.12^5 + 680/1.12^6 = 481.3.$

So, projectB should be selected using the NPV criteria.

b. The profitability index for each project if the cost of capital is 12% is:

$PIa = 161.78/500 = 0.324$ or 32.4%,

$PIb = 481.3/875 = 0.55$ or 55%.

c. The regular payback period is 5 years for project A and 4,5 years for project B, so is higher for project A.