Daisy’s Creamery Inc. is considering one of two investment options. Option 1 is a $75,000 investment in

Daisy’s Creamery Inc. is considering one of two investment options. Option 1 is a $75,000 investment in new blending equipment that is expected to produce equal annual cash flows of $19,000 for each of seven years. Option 2 is a $90,000 investment in a new computer system that is expected to produce equal annual cash flows of $27,000 for each of five years. The residual value of the blending equipment at the end of the fifth year is estimated to be $15,000. The computer system has no expected residual value at the end of the fifth year.

Assume there is sufficient capital to fund only one of the projects. Determine which project should be selected, comparing the (a) net present values and (b) present value indices of the two projects. Assume a minimum rate of return of 10%. Round the present value index to two decimal places. Use the present value tables presented in this chapter (Exhibits 1 and 2).


Answer:


a. Blending Equipment 
Equal annual cash flows for Years 1–5………………………………… 
 × Present value of a $1 annuity at 10% for five periods………………     3.791 
 Present value of operating cash flows……………………………………  $ 72,029 
 Residual value at end of fifth year……………………………………… $15,000  
 × Present value of $1 at 10% for five periods……………………………     0.621  
 Present value of of residual value…………………………………………    9,315 
 Total present value of cash flows…………………………………………  $ 81,344 
 Less amount to be invested………………………………………………     75,000 
 Net present value……………………………………………………………  $   6,344 
Computer System 
Equal annual cash flows for Years 1–5…………………………………… $27,000 
× Present value of a $1 annuity at 10% for five periods………………     3.791 
Present value of operating cash flows………………………………… $102,357 
Less amount to be invested…………………………………………………    90,000 
Net present value……………………………………………………………… $ 12,357 
b. Present value index of blending equipment: 
Present value index of computer system: 
Both the net present value calculations in part (a) and the present value index 
calculations in part (b) suggest that the computer system should be selected 
between the two options if there is sufficient capital for only one project 
investment.