A firm is considering two mutually exclusive investment alternatives, both of which cost $5,000. The firm’s hurdle rate is 12%. The after-tax cash flows associated with each investment are:
Year Investment A Investment B
1 $2,000 $1,000
2 1,500 1,500
3 1,500 2,000
4 1,000 3,000
For each alternative, calculate the payback period, the net present value, and the profitability index. Which alternative (if any) should be selected?
Answer:
Alternative A:
Payback: $2,000 + $1,500 + $1,500 = $5,000 (3 years)
NPV at 12% = ($2,000)(0.893) + ($1,500)(0.797) + ($1,500)(0.712) + ($1,000)(0.636) – $5,000 = -$314.50
PI = (1,786 + 1,196 + 1,068 + 636)/5,000 = 0.94
Alternative B:
Payback: $1,000 + $1,500 + $2,000 + $500 = $5,000
(3 + 500/3000 = 3.167 years)
NPV at 12 percent = ($1,000)(0.893) + ($1,500)(0.797)
+ ($2,000)(0.712) + ($3,000)(0.636) – $5,000 = $420.50
PI = (893 + 1,196 + 1,424 + 1,908)/5,000 = 1.08
Option B is the BEST alternative as it INCREASES shareholder wealth.
