Question
Jess Lawson is the CFO for ABC Co. She is looking at five projects for potential investment in the second half of Year 1. She
Jess Lawson is the CFO for ABC Co. She is looking at five projects for potential investment in the second half of Year 1. She has asked her senior analyst, Eric Whitelaw, to review the projects to determine which ones the company should pursue. Jess has provided two scenarios to Eric, along with the estimated cash flows for each project and appropriate discount rates. Using the information provided in the exhibits, complete the table below.
For each project in column A, calculate the profitability index in column B, rank the projects 15 (1 being the highest) based on the profitability index, and then determine whether the company should or should not pursue the project (Yes or No)
A | B | C | D |
Project | Profitability Index | Rank (1~5) | Purse (Yes/No) |
1 |
|
|
|
2 |
|
|
|
3 |
|
|
|
4 |
|
|
|
5 |
|
|
|
Present Value of $1
Discount Rates | |||||
Years | 5% | 5.50% | 6% | 6.5% | 7% |
1 | 0.9524 | 0.9479 | 0.9434 | 0.9390 | 0.9346 |
2 | 0.9070 | 0.8985 | 0.8900 | 0.8817 | 0.8734 |
3 | 0.8638 | 0.8516 | 0.8396 | 0.8278 | 0.8163 |
4 | 0.8227 | 0.8072 | 0.7921 | 0.7773 | 0.7629 |
5 | 0.7835 | 0.7651 | 0.7473 | 0.7299 | 0.7130 |
6 | 0.7462 | 0.7252 | 0.7050 | 0.6853 | 0.6663 |
Present Value of an Ordinary Annuity of $1
Discount Rates | |||||
Years | 5% | 5.50% | 6% | 6.5% | 7% |
1 | 0.9524 | 0.9479 | 0.9434 | 0.9390 | 0.9346 |
2 | 1.8594 | 1.8464 | 1.8334 | 1.8207 | 1.8080 |
3 | 2.7232 | 2.6980 | 2.6730 | 2.6485 | 2.6243 |
4 | 3.5459 | 3.5052 | 3.4651 | 3.4258 | 3.3872 |
5 | 4.3294 | 4.2703 | 4.2124 | 4.1557 | 4.1002 |
6 | 5.0756 | 4.9955 | 4.9174 | 4.8410 | 4.7665 |
Email from CFO To: From: Date: Eric Whitelaw, Senior Analyst Jess Lawson, CFO July 10, Year 1 Hello Eric, I would like you to take a look at five projects in which we are considering investments over the next couple of months. The cash flows and appropriate rates are below, and using this data I would like you to model this under two scenarios. The first is if we have unlimited capital, and we want to know how these projects would be ranked based purely on NPV provided. The second scenario is the more realistic one, in which we have a capital budget limitation of $150,000. Using the profitability index, we need to rank the projects and then decide which ones we can pursue. Here is the data: Project 1: After the initial outflow of $60,000, we would receive annual cash flows of $18,000 per year for five years. The rate I think we should use is 5.50 percent. Project 2: This project would cost us $49,000 and then provide us with inflows of $12,000, $14,000, $17,000, and $22,000, respectively, over the next four years. This project presents the lowest risk out of the five, and so a 5.00 percent discount rate is appropriate Project 3: This one is the most expensive at $78,000 up front, but would provide inflows of $20,000, $23,500, and $24,000 for Years 3-5. Given the high up-front cost, I think a rate of 6.00 percent works well here. Project 4: Of the five projects, this one is the cheapest initial investment at $19,000. Best estimates for cash inflows (which would extend for six years) are $3,000, $4,500, $4,800, and then $5,500 for Years 4-6. Even though this one isn't very expensive, I am concerned about the likelihood of us receiving those amounts that far into the future; therefore, let's use a discount rate of 7.00 percent. Project 5: This final project would cost us $28,000 and provide expected inflows of $3,500, $6,000, $9,800, $10,000, and $10,000. 6.50 percent is a good rate to use for this one. The other thing I am interested in is how long it would take to get our money back on these investmentswhich I think the basic payback period calculations can provide. If you can let me know the results for all of these items by the end of the day tomorrow, I would appreciate it. Thank you, Jess
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