A firm is considering three mutually exclusive alternatives as part of a product

Question

A firm is considering three mutually exclusive alternatives as part of a production improvement program. The alternatives are, Alternatives Cash flow A B C Installed cost $12,250 $14,000 $16,500 Uniform annual Benefit $ 2,750 $ 2,700 $ 2,950 Salvage value $ 1,500 $ 2,500 $ 5,500 Useful life in Years 8 12 12 Due to the unknown rate of technology transfer, the project life of the improvement program is unknown. The firm has a MARR of 15.0%. Use net present worth analysis to determine which alternative should it select?

Explanation / Answer

Opportunity cost for you is 10%. That seems to be the interest rate that you can earn by lending the money to borrower or bank. So, you should choose the discount rate of 10% for NPV calculations. However, this applies to your second project. But for the first project is based on 25% of the investment funded by borrowing whose cost is 15%. So, your weighted cost of funds is (0.75*10 +0.25*15) = 11.25. So, the discount rate should be 11.25% for the first project. Remember, however, not to include the interest paymrents as a cost by deduction it from the cashflows.
But you want a choice between either 10% or 15%. Then you choose 15% as the discount rate for calculating NPV for both the projects. So long as there is no switching point between 10% and 15%, there is no problem.
For IRR calculations, no discount rate has to be chosen. You have to find the discount rate at which the NPV is zero. Once you have soled the equation and found the IRR you have to compare the IRR with the weighted cost of investment (11.25% for the first project and 10% for the second). If the IRR is higher than the weighted cost of capital, the project is acceptable. But which project to choose. Choose the one with the higher IRR.So we can say that we will use alternative no. B

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