Question

Exercise 24-4 BAK Corp. is considering purchasing one of two new diagnostic machines. Either machine would make it possible for the company to bid on jobs that it currently isn't equipped to do. Estimates regarding each machine are provided below. Machine A Machine B Original cost $77.500 116,000 Estimated life 8 years 8 years Salvage value Estimated annual cash inflows $19,500 $39,600 Estimated annual cash outflows $5,040 $9,800 Click here to view PV table. Calculate the net present value and profitability index of each machine Assume a discount rate. (If the net present value is negative, weather a negative in preceding the number eg-45 or parentheses eg (45). Round answer for present value to decimal places 125 and profita Index to 2 decimal places, 9. 10:50. For calculation purposes, use decimal places as displayed in the factor table provided) Machine A Machine Net present value Profitability index Which machine should be purchased should be purchased

Answer 1

	Computation	Machine A	Machine B
Annual cash inflows	a	$     19,500	$       39,600
Annual cash outflows	b	$     (5,040)	$       (9,800)
Annual net cash inflows	c = a - b	$     14,460	$       29,800
PVAF (9%, 8 years)	d	5.53482	5.53482
Present value of annual net cash inflows	e = c × d	$     80,033	$   1,64,938
Initial investment	f	$     77,500	$   1,86,000
Net present value	e - f	$       2,533	$     (21,062)
Profitability index	e ÷ f	1.03	0.89

NPV

• Net present value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows over the life of an investment project.
• NPV is used to evaluate investment projects in capital budgeting.
• A project with a positive NPV is accepted. A positive NPV indicates that the project will result in net cash inflows in today's dollars.
• A project with a negative NPV is rejected. A negative NPV indicates that the project will result in net cash outflows in today's dollars.
• The cash flows are discounted at a required rate of return. It may be a weighted average cost of capital, cost of debt, etc.

PROFITABILITY INDEX

• Profitability index = PV of expected cash inflows ÷ Initial investment (i.e. outflow)​​​​​​
• If Profitability index > 1, the project should be accepted.
• If Profitability index < 1, the project should be rejected.
• If Profitability index = 1, the project is indifferent (i.e. no difference in accepting or rejecting the project)

WHICH MACHINE SHOULD BE PURCHASED?

Machine A should be purchased. (since it has a positive NPV as well as Profitability index > 1)

1 - (1r) -n PVAF r

• r = discount rate = 9%
• n = number of years = 8 years

PVAF = (1 - (1.09)^-8) ÷ 0.09 = 5.53482