The management of Revco Produc
The management of Revco Products is exploring four differentinvestment opportunities. Information on the four projects understudy follows:
| Project Number | ||||||||||||
| 1 | 2 | 3 | 4 | |||||||||
| Investment required | $ | (610,000) | $ | (560,000) | $ | (410,000 | ) | $ | (320,000) | |||
| Present value of cash inflows at a 8% discount rate | $ | 647,538 | $ | 648,059 | $ | 471,500 | $ | 360,735 | ||||
| Net present value | $ | 37,538 | $ | 88,059 | $ | 61,500 | $ | 40,735 | ||||
| Life of the project | 6 years | 12 years | 6 years | 3 years | ||||||||
| Internal rate of return | 10 | % | 11 | % | 13 | % | 15 | % | ||||
Because the company’s required rate of return is 8%, a 8%discount rate has been used in the present value computationsabove. Limited funds are available for investment, so the companycan’t accept all of the available projects.
Required:
1. Compute the project profitability index for each investmentproject.
2. Rank the four projects according to preference, in terms ofnet present value, project profitability index and internal rate ofreturn.
Answer:
Solution:
A) Project Profitability Index:
Profitability of Index = Net Present Value / InvestmentRequired
| Calculation of ProfitabilityIndex | ||||
| Particulars | Project -1 | Project -2 | Project -3 | Project -4 |
| Investment Required (A) | 6,10,000 | 5,60,000 | 4,10,000 | 3,20,000 |
| Net Present Value (B) | 37,538 | 88,059 | 61,500 | 40,735 |
| Profitability Index(B/A) | 0.061538 | 0.157248 | 0.150000 | 0.127297 |
| Investment Proposal | Project Profitability Index |
| Project – 1 | 0.06154 |
| Project – 2 | 0.15725 |
| Project – 3 | 0.15000 |
| Project – 4 | 0.12730 |
B. Project Preference Ranks:
| Particulars | Net PresentValue | ProfitabilityIndex | Internal Rate ofReturn |
| First Preference | 2 | 2 | 4 |
| Second Preference | 3 | 3 | 3 |
| Third Preference | 4 | 4 | 2 |
| Fourth Preference | 1 | 1 | 1 |
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