The D. Dorner Farms Corporation is considering purchasing one of two fertilizer-herbicides for the upcoming year. The more expensive of the two is better and will produce a higher yield. Assume these projects are mutually exclusive and that the required rate of return is 10 percent. Given the following free cash flows: Product A Product B
Initial outlay -$5000 -$5000
Inflow year 1 700 6,000

Required:
a. Calculate the NPV of each project.
b. Calculate the PI of each project.
c. Calculate the IRR of each project.
d. If there is no capital-rationing constraint, which project should be selected? If there is a capital-rationing constraint, how should the decision be made?

Question Correction:

The question stated that there is a more expensive fertilizer-herbicide.  Therefore, their initial outlays cannot be equal as stated.  Instead, the correct cash flows, including initial outlays are:

                   Product A  Product B

Initial outlay    -$500      -$5000

Inflow year 1       700        6,000

The D. Dorner Farms Corporation

                        Product A  Product B

a. NPV =               $136          $454

b. PI =                  1.272           1.091

c. IRR =               27.2%        9.08%

d. If there is no capital-rationing constraint, Project B should be chosen despite its poor PI and IRR performances, but for returning a larger NPV.

e. If there is a capital-rationing constraint, Project A should be chosen because of its more impressive PI and IRR performances.

Explanation:

a) Data and Calculations:

Required rate of return for the projects = 10%

Present factor of 10% for 1 year = 0.909

Free cash flows:

                   Product A  Product B

Initial outlay    -$500      -$5000

Inflow year 1       700        6,000

Present values:

                   Product A  Product B

Initial outlay    -$500      -$5000

Inflow year 1      636         5,454

NPV =               $136          $454

b) PI (Profitability Index) is a useful tool in capital budgeting which measures the profit potential of a project in order to ease decisions.  It is computed by dividing the present value of cash inflows by the initial investment cost.  Another formula is: 1 + (NPV/Initial outlay).

Therefore, the PI for each project is calculated as follows:

PI =            1+ (NPV/Initial outlay)

                   Product A             Product B

PI =      1 + ($136/$500)         1 + ($454/$5,000)

=                1.272                     1.091

IRR (Internal Rate of Return) = NPV/Initial Outlay

                   Product A                     Product B

IRR =          $136/$500 * 100           $454/$5,000 * 100

=                 27.2%                             9.08%