The D. Dorner Farms Corporation is considering purchasing one of two fertilizer-herbicides for the upcoming year. The more expensive of the two is better and will produce a higher yield. Assume these projects are mutually exclusive and that the required rate of return is 10 percent. Given the following free cash flows:
Product A Product B
Initial outlay -$5000 -$5000
Inflow year 1 700 6,000
Required:
a. Calculate the NPV of each project.
b. Calculate the PI of each project.
c. Calculate the IRR of each project.
d. If there is no capital-rationing constraint, which project should be selected? If there is a capital-rationing constraint, how should the decision be made?
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Ответ:
Question Correction:
The question stated that there is a more expensive fertilizer-herbicide. Therefore, their initial outlays cannot be equal as stated. Instead, the correct cash flows, including initial outlays are:
Product A Product B
Initial outlay -$500 -$5000
Inflow year 1 700 6,000
The D. Dorner Farms Corporation
Product A Product B
a. NPV = $136 $454
b. PI = 1.272 1.091
c. IRR = 27.2% 9.08%
d. If there is no capital-rationing constraint, Project B should be chosen despite its poor PI and IRR performances, but for returning a larger NPV.
e. If there is a capital-rationing constraint, Project A should be chosen because of its more impressive PI and IRR performances.
Explanation:
a) Data and Calculations:
Required rate of return for the projects = 10%
Present factor of 10% for 1 year = 0.909
Free cash flows:
Product A Product B
Initial outlay -$500 -$5000
Inflow year 1 700 6,000
Present values:
Product A Product B
Initial outlay -$500 -$5000
Inflow year 1 636 5,454
NPV = $136 $454
b) PI (Profitability Index) is a useful tool in capital budgeting which measures the profit potential of a project in order to ease decisions. It is computed by dividing the present value of cash inflows by the initial investment cost. Another formula is: 1 + (NPV/Initial outlay).
Therefore, the PI for each project is calculated as follows:
PI = 1+ (NPV/Initial outlay)
Product A Product B
PI = 1 + ($136/$500) 1 + ($454/$5,000)
= 1.272 1.091
IRR (Internal Rate of Return) = NPV/Initial Outlay
Product A Product B
IRR = $136/$500 * 100 $454/$5,000 * 100
= 27.2% 9.08%
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Explanation: