to keep his business looking current and trendy, but he is anything but “pumped" about spending this much money on a lighting display. Based on significant research and discussions with friends in the industry, he makes the following esti- mates to go along with each bid. Bid 1 Bid 2 Bid 3 Cost of lighting, installed $80,000 $100,000 $75,000 Additional annual revenues 15,000 17,000 15,000 Additional annual operating costs 1,800 2,500 3,000 The useful life of all three lighting schemes is 15 years, at which point none of them would have any salvage value. Ralph's station is subject to a 25% tax rate and has a required rate of return of 8% on new projects. Required a. Determine the present value of the future cash flows for each bid, then determine the NPV of each bid overall. b. Calculate the profitability index for each bid and then rank the three bids accordingly. Describe in words what the profitability index means in the context of the bid with the highest profitability index. c. Does your quantitative analysis suggest that an investment in LED lighting is almost certainly going to pay off for Ralph? Is there a clear choice in bids based on the NPV and/or profitability index? In the end, what other qualitative factors might help the owner decide which bid to accept, if any?
to keep his business looking current and trendy, but he is anything but “pumped" about spending this much money on a lighting display. Based on significant research and discussions with friends in the industry, he makes the following esti- mates to go along with each bid. Bid 1 Bid 2 Bid 3 Cost of lighting, installed $80,000 $100,000 $75,000 Additional annual revenues 15,000 17,000 15,000 Additional annual operating costs 1,800 2,500 3,000 The useful life of all three lighting schemes is 15 years, at which point none of them would have any salvage value. Ralph's station is subject to a 25% tax rate and has a required rate of return of 8% on new projects. Required a. Determine the present value of the future cash flows for each bid, then determine the NPV of each bid overall. b. Calculate the profitability index for each bid and then rank the three bids accordingly. Describe in words what the profitability index means in the context of the bid with the highest profitability index. c. Does your quantitative analysis suggest that an investment in LED lighting is almost certainly going to pay off for Ralph? Is there a clear choice in bids based on the NPV and/or profitability index? In the end, what other qualitative factors might help the owner decide which bid to accept, if any?
Essentials Of Investments
11th Edition
ISBN:9781260013924
Author:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Publisher:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Chapter1: Investments: Background And Issues
Section: Chapter Questions
Problem 1PS
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Transcribed Image Text:**Chapter 7: Capital Budgeting Choices and Decisions**
Ralph, the local gas station owner, is considering an investment in LED lighting displays around his fuel pumps. This decision aims to differentiate his station from a nearby competitor. Despite his reluctance to spend a substantial amount of money on lighting, Ralph understands the need for such an investment. After conducting extensive research and consultations within the industry, he has obtained bids from three credible companies. However, none have previously worked with him.
**Bids and Estimates:**
- **Bid 1:**
- Cost of lighting, installed: $80,000
- Additional annual revenues: $15,000
- Additional annual operating costs: $1,800
- **Bid 2:**
- Cost of lighting, installed: $100,000
- Additional annual revenues: $17,000
- Additional annual operating costs: $2,500
- **Bid 3:**
- Cost of lighting, installed: $75,000
- Additional annual revenues: $15,000
- Additional annual operating costs: $3,000
The useful life of all three lighting schemes is 15 years, with no salvage value at the end. Ralph’s station faces a 25% tax rate and requires an 8% return on new projects.
**Required:**
a. **Determine the Present Value (PV):** Calculate future cash flows for each bid, and determine the overall Net Present Value (NPV).
b. **Calculate Profitability Index:** Rank each bid using the profitability index and explain the significance of this index relative to the bid with the highest value.
c. **Analyze Decision-Making Factors:** Evaluate whether investing in LED lighting is financially beneficial based on NPV and profitability index. Consider qualitative factors that might influence bid selection.
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