Decision Making with Managerial Accounting
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Net Present Value (NPV) is one of the decision-making criteria in Capital Budgeting. The formula is NPV = - Initial Investment (I)+ Present Value of future Cash flows (PV). From this relation, we get, PV = NPV + I. This equation demonstrates when NPV is greater than zero, PV is greater than Initial Investment I or PV > I. This relationship derives that the ratio of PV to I is always greater than 1. Profitability Index (PI) is the ratio that displays the relationship between Present values of all future cash flows (PV) to initial investment (I). This is an investment appraisal technique. This ratio displays per dollar return. Projects are accepted for PI greater than 1.
Problem 1.
Assumption: We do not consider project “D” with negative NPV, and assume equal life cycles for all projects.
Solution: Based on values of PI, we made three choices: option 1, option 2, and option 3. Option 1 consists of five projects totaling $1.2 million capital investment; option 2 consists of five projects totaling $1,175 million; option 3 consists of four projects totaling $1,2 million. We combined all projects in one and calculated PI of each option. PI ratios are respectively 1.10, 1.11, and 1.11 for option 1, option 2, and option 3. Though, option 2 and option 3 have same PI; option 2 generates additional money through surplus funds for $25,000. We selected option 2.
Proposed Investments
|
Projects |
Net Investment |
NPV |
PI |
Position per PI |
|
J |
250,000 |
35,000 |
1.14 |
1 |
|
F |
250,000 |
30,000 |
1.12 |
2 |
|
A |
200,000 |
22,000 |
1.11 |
3 |
|
H |
200,000 |
18,000 |
1.09 |
4 |
|
B |
275,000 |
21,000 |
1.08 |
5 |
|
E |
500,000 |
40,000 |
1.08 |
5 |
|
G |
100,000 |
7,000 |
1.07 |
6 |
|
G |
100,000 |
7,000 |
1.07 |
6 |
|
I |
210,000 |
4,000 |
1.02 |
7 |
|
Projects |
Net Investment |
NPV |
PI |
Position |
Projects |
Net Investment |
NPV |
PI |
Position |
|
J |
250,000 |
35,000 |
1.14 |
1 |
J |
250,000 |
35,000 |
1.14 |
1 |
|
F |
250,000 |
30,000 |
1.12 |
2 |
F |
250,000 |
30,000 |
1.12 |
2 |
|
E |
500,000 |
40,000 |
1.08 |
5 |
A |
200,000 |
22,000 |
1.11 |
3 |
|
G |
100,000 |
7,000 |
1.07 |
6 |
H |
200,000 |
18,000 |
1.09 |
4 |
|
G |
100,000 |
7,000 |
1.07 |
6 |
B |
275,000 |
21,000 |
1.08 |
5 |
|
|
1,200,000 |
119,000 |
1.10 |
|
|
1,175,000 |
126,000 |
1.11 |
|
|
Projects |
Net Investment |
NPV |
PI |
Position |
|
E |
500,000 |
40,000 |
1.08 |
5 |
|
J |
250,000 |
35,000 |
1.14 |
1 |
|
F |
250,000 |
30,000 |
1.12 |
2 |
|
A |
200,000 |
22,000 |
1.11 |
3 |
|
|
1,200,000 |
127,000 |
1.11 |
|
Problem 2.
Assumption: We reject project “D” from the selection because of negative NPV, and consider life cycles for all choices is equal.
Solution: Selection criterion is to maximize net NPV. We can find only one combination. The total NPV of this option is 127,000. Any other combination would produce NPV lower than this value.
Selected projects
|
Projects |
Investment |
NPV |
|
J |
250,000 |
35,000 |
|
F |
250,000 |
30,000 |
|
E |
500,000 |
40,000 |
|
A |
200,000 |
22,000 |
|
|
1,200,000 |
127,000 |
Problem 3 (a)
Assumption: We reject project D, and assume life cycle for all projects is equal.
Solution: We get two options for capital investment $1.0 million: option 1 and option2. Option 1 gives net capitalization of NPV $105,000, and option 2 gives $112,000. We selected option 2. The reduction of $ 200,000 makes changes in the list of accepted projects from part2.
Option 1 Option 2
|
Projects |
Investment |
NPV |
Projects |
Net Investment |
NPV |
|
J |
250,000 |
35,000 |
J |
250,000 |
35,000 |
|
F |
250,000 |
30,000 |
F |
250,000 |
30,000 |
|
E |
500,000 |
40,000 |
A |
200000 |
22000 |
|
|
1,000,000 |
105,000 |
H |
200000 |
18000 |
|
|
|
|
G |
100000 |
7000 |
|
|
|
|
|
1,000,000 |
112,000 |
Problem 3 (b)
Elimination of $200,000 required new capital budgeting arrangements. Selection criterion is capitalization of NPV. Eliminated $ 200,000 lost opportunity of project A and H, however, between these two projects, A gives higher NPV and PI than the project H. In this case, the opportunity cost of eliminated $ 200,000 is $22,000 NPV. We assumed equal life cycles for all projects.
