AMCE 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:
Alternative 1 Alternative 2
Required investment outlay $170,000 $100,000
Incremental after-tax cash inflows/year $50,000 $30,000
Estimated project life (in years) 5 5
Estimated salvage value (end of life) $0 $0
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.)
Compute the profitability index (PI) for each alternative and state which alternative, based on PI, is more desirable.
Why do the project rankings differ under the two methods of analysis? Which alternative would you recommend, and why?