Question

Shenandoah Springs Company is considering two investment opportunities whose cash flows are provided below:

Year Investment A Investment B
0 $ (15,000 ) $ (9,000 )
1 5,000 5,000
2 5,000 4,000
3 5,000 3,000
4 4,000 1,000
The company's hurdle rate is 12%. What is the present value index of Investment B?

Answer 1

Consider the following calculations

Step-by-step explanation:

We need to work out the net after tax cash flows for each of the five years of the project, which are calculated as follows:

Net annual cash flows = annual cash inflows – annual cash outflows

INVESTMENT A = 15000- (5000+5000+5000+4000) = -4000

INVESTMENT B = 9000- (5000+4000+3000+1000) =-4000

HURDLE RATE = 12 %

The present value factor for 4 years annuity is 3.0373

INVESTMENT A

Present value of future net cash flows = 3.0373* $4000 = $12149.39

INVESTMENT B

Present value of future net cash flows = 3.0373* $4000 = $12149.39

HENCE PRESENT VALUE IS GREATER THAN INITIAL FLOW.. HENCE IT SHOULD BE ACCEPTED

Answer 2

PV Index = 1.158

Step-by-step explanation:

Present value index is the ratio of discounted cash flows of the project divided by initial outlay required for the project thus first we calculate the Present Values for Investment B

Present value factors @ 12% for year 0, 1, 2, 3, 4 respectively.

1

0.893

0.797

0.712

0.636

Net Present Value = -9000 + (5000 * 0.893) + (4000 * 0.797) + (3000 * 0.712) + (1000 * 0.636)

NPV = $1425

Present value Index = NPV / Initial investment = 1425/9000 = 0.158

This can be interpreted as 1 + 0.158 = 1.158,

1 being the initial investment. You can also choose not to subtract the initial outlay when calculating NPV.

Hope that helps.