Question

I am stuck in this problem, can someone help

What is the profntability index ratio for the incremental analysis between the two projects and which project would be chosen if only one of the two projects could be selected Capital 1,500,000 $1,400,000 Investment Project Life 30 30 Annual Benefits $260,000 $240,000 Annual Costs $120,000 $110,000 Salvage Value $90,000 $80,000 7% Discount Rate 7% 1.113,B 1.254,A 1.254,B 1.113,A

Answer 1

First we analyze both projects by calculating individual PI

Let us consider the project A

Initial Cost=I=1500000

Net benefits per year=NB=260000-120000=$140000

Salvage value=S=$90000

PV of future cash flows=NB*(P/A,7%,30)+S*(P/F,7%,30)

Let us calculate interest factors

(P/A, i, n) =-(1邢

(1+0.0 =- = 12.409041 (PA 0.07.30) 0,07

(P/F,0.06.15)=1/(1+0.07)^30=0.131367

PV of future cash flows=140000*12.409041+90000*0.131367=$1749088.77

PI=PV of future cash flows/Initial Cost=1749088.77/1500000=1.1660

Let us consider the project B

Initial Cost=I=1400000

Net benefits per year=NB=240000-110000=$130000

Salvage value=S=$80000

PV of future cash flows=NB*(P/A,7%,30)+S*(P/F,7%,30)

PV of future cash flows=130000*12.409041+80000*0.131367=$1623684.69

PI=PV of future cash flows/Initial Cost=1623684.69/1400000=1.1598

We find value of PI is more than 1 for both cases, both are acceptable.

Now we carry out incremental PI analysis.

Project B has lower cost. So, it is base case.

Incremental Initial Cost=Ii=1500000-1400000=$100,000

Incremental Net benefits per year=NBi=140000-130000=10000

Incremental Salvage value=Si=$90000-80000=$10000

PV of incremental future cash flows=NBi*(P/A,6%,15)+Si*(P/F,6%,15)

PV of future cash flows=10000*12.409041+10000*0.131367=$125404.08

Incremental PI=PV of incremental future cash flows/Incremental Initial Cost

= 125404.08/100000=1.2540

We can see incremental PI is higher than 1, it is advisable to incur extra expenditure on project A. We should select project A

Correct Option is

1.254 A