Wednesday, 9 July 2014

The Angry Bird Corporation is trying to choose between the following two mutually exclusive design projects:

The Angry Bird Corporation is trying to choose between the following two mutually exclusive design projects:

Year Cash Flow (I) Cash Flow (II)
0 –$ 68,000 –$ 17,600
1 31,000 9,500
2 31,000 9,500
3 31,000 9,500

   
a-1
If the required return is 12 percent, what is the profitability index for both projects? (Round your answers to 3 decimal places. (e.g., 32.161))
  
Profitability
Index
  Project I  
  Project II  


a-2
If the company applies the profitability index decision rule, which project should the firm accept?
Project Il
  
b-1
What is the NPV for both projects? (Negative amounts should be indicated by a minus sign. Round your answers to 2 decimal places. (e.g., 32.16))
  
NPV
  Project I $  
  Project II $  

  
b-2
If the company applies the NPV decision rule, which project should it take?
Project I

rev: 12_03_2012


Explanation:a.
The profitability index is the PV of the future cash flows divided by the initial investment. The cash flows for both projects are an annuity, so:
PII = $31,000(PVIFA12%,3) / $68,000 = 1.095
PIII = $9,500(PVIFA12%,3) / $17,600 = 1.296
The profitability index decision rule implies that we accept project II, since PIII is greater than the PII.

b.

The NPV of each project is:
NPVI = –$68,000 + $31,000(PVIFA12%,3) = $6,456.77
NPVII = –$17,600 + $9,500(PVIFA12%,3) = $5,217.40
The NPV decision rule implies accepting Project I, since the NPVI is greater than the NPVII.
  
Calculator Solution:
Note: Intermediate answers are shown below as rounded, but the full answer was used to complete the calculation.
  
Project I
CFo
 $0
CFo
 –$68,000
C01
 $31,000
C01
 $31,000
F01
 3
F01
 3
  I = 12%   I = 12%
  NPV CPT   NPV CPT
  $64,849.44   $6,456.77
  
PI = $64,849.44 / $68,000 = 1.095
   
Project II
CFo
 $0
CFo
 –$17,600
C01
 $9,500
C01
 $9,500
F01
 3
F01
 3
  I = 12%   I = 12%
  NPV CPT   NPV CPT
  $22,817.40   $5,217.40
  
PI = $22,817.40 / $17,600 = 1.296