Perit Industries has $170,000 to invest. The company is trying to decide between two alternative uses of the funds. The alternatives are:
| Project A | Project B | |||
| Cost of equipment required | $ | 170,000 | $ | 0 |
| Working capital investment required | $ | 0 | $ | 170,000 |
| Annual cash inflows | $ | 26,000 | $ | 43,000 |
| Salvage value of equipment in six years | $ | 8,700 | $ | 0 |
| Life of the project | 6 years | 6 years | ||
The working capital needed for project B will be released at the end of six years for investment elsewhere. Perit Industries’ discount rate is 14%.
Required:
1. Compute the net present value of Project A. (Enter negative values with a minus sign. Round your final answer to the nearest whole dollar amount.)
2. Compute the net present value of Project B. (Enter negative values with a minus sign. Round your final answer to the nearest whole dollar amount.)
3. Which investment alternative (if either) would you recommend that the company accept?
Explanation
1.
Project A:
| Now | Years 1-6 | Year 6 | ||||||||||||
| Purchase of equipment | $ | (170,000 | ) | |||||||||||
| Annual cash inflows | $ | 26,000 | ||||||||||||
| Salvage value | $ | 8,700 | ||||||||||||
| Total cash flows (a) | $ | (170,000 | ) | $ | 26,000 | $ | 8,700 | |||||||
| Discount factor (14%) (b) | 1.000 | 3.889 | 0.456 | |||||||||||
| Present value (a) × (b) | $ | (170,000 | ) | $ | 101,114 | $ | 3,967 | |||||||
| Net present value | $ | (64,919 | ) | |||||||||||
Project B:
| Now | Years 1-6 | Year 6 | ||||||||||||
| Working capital invested | $ | (170,000 | ) | |||||||||||
| Annual cash inflows | $ | 43,000 | ||||||||||||
| Working capital released | $ | 170,000 | ||||||||||||
| Total cash flows (a) | $ | (170,000 | ) | $ | 43,000 | $ | 170,000 | |||||||
| Discount factor (14%)(b) | 1.000 | 3.889 | 0.456 | |||||||||||
| Present value (a) × (b) | $ | (170,000 | ) | $ | 167,227 | $ | 77,520 | |||||||
| Net present value | $ | 74,747 | ||||||||||||
3.
The $170,000 should be invested in Project B rather than in Project A. Project B has a positive net present value whereas Project A has a negative net present value.
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