Sunshine Corporation is considering several long-term investments. Management wants to
accept the two best projects, given the following data:
Project
A B C D E
Present value of
net cash inflows . . . . . . . . $24,000 $44,000 $15,000 $30,000 $50,000
Investment cost . . . . . . . . . . 20,000 40,000 16,000 24,000 41,000
Required:
1. Determine the net present value and the profitability index for each project.
2. Which projects are acceptable using the profitability index as a screening tool?
3. What would be the ranking of the acceptable projects according to the profitability indexes?
4. Interpretive Question: What additional information would be needed to screen and rank
the projects using the internal rate of return method? What are the decision rules using the
IRR method for screening and ranking capital budgeting projects?
To determine the net present value (NPV) and the profitability index for each project, we need to calculate these values using the provided data. Let's go step by step:
1. Net Present Value (NPV):
The NPV of each project is calculated by subtracting the investment cost from the present value of net cash inflows. The formula for NPV is:
NPV = Present Value of Net Cash Inflows - Investment Cost
Project A: NPV = $24,000 - $20,000 = $4,000
Project B: NPV = $44,000 - $40,000 = $4,000
Project C: NPV = $15,000 - $16,000 = -$1,000
Project D: NPV = $30,000 - $24,000 = $6,000
Project E: NPV = $50,000 - $41,000 = $9,000
2. Profitability Index:
The profitability index is calculated by dividing the present value of net cash inflows by the investment cost. The formula for the profitability index is:
Profitability Index = Present Value of Net Cash Inflows / Investment Cost
Project A: Profitability Index = $24,000 / $20,000 = 1.2
Project B: Profitability Index = $44,000 / $40,000 = 1.1
Project C: Profitability Index = $15,000 / $16,000 = 0.9375
Project D: Profitability Index = $30,000 / $24,000 = 1.25
Project E: Profitability Index = $50,000 / $41,000 = 1.2195
3. Ranking of Acceptable Projects According to Profitability Index:
To determine the ranking, we arrange the projects in descending order of their profitability index. The ranking is as follows:
1. Project D (Profitability Index: 1.25)
2. Project E (Profitability Index: 1.2195)
3. Project A (Profitability Index: 1.2)
4. Project B (Profitability Index: 1.1)
5. Project C (Profitability Index: 0.9375)
4. Additional Information for Internal Rate of Return (IRR) Method:
To screen and rank projects using the internal rate of return method, we would need the discount rate or the hurdle rate. The IRR is the discount rate at which the NPV becomes zero, and it is used to evaluate the profitability of an investment.
Decision Rules for IRR Method:
- If the IRR is greater than the required rate of return (hurdle rate), the project is considered acceptable.
- Projects with a higher IRR are given higher priority in the ranking.
Without the discount rate or hurdle rate, we cannot calculate the IRR and make decisions based on it.
I hope this helps you understand how to calculate NPV, profitability index, and how to use IRR for screening and ranking capital budgeting projects.