Olourun Ltd is the major employer in the Front Hill area, where the firm is located. The company is considering the acquisition of a new production line. The equipment would cost$720 000 and installation cost would amount to $59 000. At the end of its 5-year life, it is expected to be disposed of at its salvage value of $70 000. The new equipment would allow the company to expand production significantly, which would require an increase in working capital of $90 000. If the purchase is made, the firm's maintenance costs would be reduced by $60 000 annually. However, at the end of the third year, a major overhaul would have to be undertaken at a cost of $80 000. Operating cash flows would be $220 000 in the first year; this would increase by 2% for each of the following years.

The company's cost of capital is 14% and the relevant corporate tax rate is 25%

Question: The company is considering another investment which would have an initial cost of $800 000 and an NPV of $65000.There is a situation of capital rationing, and you have suggested that the firm should use the profitability index to choose which investment to implement. Advise the company.

Answer rating: 100% (QA)

To determine which investment to implement using the profitability index we need to calculate the pr... View the full answer