Slumber Company is considering two mutually exclusive investment alternatives.Its estimated weighted-average cost of capital,used as the discount rate for capital budgeting purposes,is 10%.Following is information regarding each of the two projects:

Question

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Required:
1.Compute the estimated net present value of each project and determine which alternative,based on NPV,is more desirable.(The PV annuity factor for 10%,5 years,is 3.7908. )
2.Compute the profitability index (PI)for each alternative and state which alternative,based on PI,is more desirable.
3.Why do the project rankings differ under the two methods of analysis? Which alternative would you recommend,and why?
Please see Feedback for answers.
 Feedback: 1.and 2. 11ea6e70_bd0b_a1c1_8f54_3108f11c9e6c_TB1699_00 Notes: a = $189,540/$170,000 b = $113,724/$100,000
Therefore,alternative 1 is preferred using the NPV criterion while alternative 2 is preferred under the profitability index (PI)ranking.
3.The net present value method determines the magnitude of the difference between the present value of cash inflows and cash outflows,while the profitability index,intuitively,calculates the ratio of return (PV of cash inflows)to investment (PV of cash outflows).The net present value method does not inherently distinguish between projects with different magnitudes of investment,while the profitability index ranking does.The choice between these two mutually exclusive alternatives for Lebar Company may depend on qualitative factors that distinguish the two alternatives,as well as other possible uses for available funds if Lebar chooses alternative 2.

Slumber Company Is Considering Two Mutually Exclusive Investment Alternatives