A firm that purchases electricity from the local utility for $350,00 per year is

Question

A firm that purchases electricity from the local utility for $350,00 per year is considering installing a steam generator at a cost of $290,000. The cost of operating this generator would be $200,000 per year, and the generator will last for five years. If the firm buys the generator, t does not need to purchase any electricity from the local utility. The cost of capital is 11%. For the local utility option, consider five years of electricity purchases. For the generator option, assume immediate installation, with purchase and operating costs in the current year and operating costs continuing for the next four years. Assume payments under both options at the start of each year (l.e., immediate, one year from now,..,. our years from now). What is the net present value of the more attractive choice?

Explanation / Answer

Solution:

As Present value of cash outflows for steam generator is lower than local utility option, therefore purchase of steam generator is more attractive choice.

Net present value of Plan B = $978,743

Computation of Net Present value Particulars Amount Period PV Factor Present Value Plan A - Local utility option Annual purchase cost $350,000.00 0-4 3.44371 $1,205,300 Present Value of Cash Outflows - Plan A $1,205,300 Plan B - Installation of Steam Generator: Initial investment $290,000.00 0 1.00000 $290,000 Annual cost of operating generator $200,000.00 0-4 3.44371 $688,743 Present Value of Cash Outflows - Plan B $978,743

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