Comparing Projects X and Y for Bell Manufacturing
Bell Manufacturing needs to choose between Project X and Project Y for warehouse expansion. Here's a comparison using four project evaluation methods and a recommendation:
1. Net Present Value (NPV):
NPV considers the time value of money and calculates the present value of all future cash flows for each project. The project with the higher NPV is preferred.
Calculation:
We'll need a financial calculator or spreadsheet function to calculate NPV. Here's the formula:
NPV = - Initial Investment + CF1/(1+r)^1 + CF2/(1+r)^2 + ... + CFn/(1+r)^n
where:
- r = cost of capital (15%)
- CF = cash flow in each year (from the table)
- n = number of years (5)
Calculate NPV for Project X and Project Y.
Choose the project with the higher NPV.
2. Internal Rate of Return (IRR):
IRR is the discount rate that makes the NPV of a project equal to zero. A project with an IRR higher than the cost of capital is considered acceptable.
Calculation:
IRR can be found using a financial calculator or spreadsheet function.
Calculate IRR for Project X and Project Y.
Choose the project with the IRR higher than the cost of capital (15%).
3. Payback Period:
Payback period is the number of years it takes for the project's cumulative cash flows to equal the initial investment. A shorter payback period indicates faster recovery of the initial investment.
Calculation:
Calculate the payback period for each project by adding up the annual cash flows until they reach the initial investment.
Choose the project with the shorter payback period.
4. Profitability Index (PI):
PI is the ratio of the project's NPV to its initial investment. A PI greater than 1 indicates a positive NPV and potential profitability.
Calculation:
Calculate the PI for each project using the previously calculated NPVs and the initial investment.
Choose the project with the higher PI.
Recommendation:
After calculating the NPV, IRR, payback period, and PI for both projects, compare the results. The project with the higher NPV, IRR that exceeds the cost of capital, shorter payback period, and higher PI is generally considered the better option.
Note:
Financial professionals may prioritize different evaluation methods depending on the specific circumstances. Some may prioritize faster cash recovery (payback period) while others may focus on long-term profitability (NPV).
By considering all four methods, Bell Manufacturing can make a more informed decision about which project (X or Y) is better suited for their warehouse expansion needs.
