A firm that purchases electricity from the local utility for $400,000 per year i
ID: 2615164 • Letter: A
Question
A firm that purchases electricity from the local utility for $400,000 per year is considering installing a steam generator at a cost of $290,000. The cost of operating this generator would be $280,000 per year, and the generator will last for five years. If the firm buys the generator, it does not need to purchase any electricity from the local utility. The cost of capital is 15%. 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 years, Assume payments under both options at the start of each year (ie, Immediate, one year from now., four year and operating costs continuing for the next four years from now). What is the net present value of the more attractive choice? Please round your answer to the nearest dollar. Report the NPV of cost as a negative number.Explanation / Answer
LOCAL UTILITY OPTION Present Value(PV) of Cash Flow= Cash flow/((1+i)^N) i= discount rate=Cost of capital=15%=0.15 N=Year of cash flow Year wise cash flow and PV of cash flows given below: Immediate Cash flow (Year0) ($290,000) Cash flow in year0 to 4 ($280,000) Total Cash flow in year0 (290000+2800000 ($570,000) N A B=A/(1.15^N) Year Cash flow PV of Cash Flow 0 ($570,000) -570000 1 ($280,000) -243478.2609 2 ($280,000) -211720.2268 3 ($280,000) -184104.5451 4 ($280,000) -160090.9088 SUM -1369393.942 Net Present value for option of loacal utility (Generator purchase) $ (1,369,394) ELECTRICITY PURCHASE OPTION Year wise cash flow and PV of cash flows given below: Immediate Cash flow (Year0) ($400,000) Cash flow in year1 to 4 ($400,000) N A B=A/(1.15^N) Year Cash flow PV of Cash Flow 0 ($400,000) -400000 1 ($400,000) -347826.087 2 ($400,000) -302457.4669 3 ($400,000) -263006.493 4 ($400,000) -228701.2982 SUM -1541991.345 Net Present value for option of Electricity Purchase $ (1,541,991) Net Present Value of more attractive option $ (1,369,394) More Attractive option Generator Purchase LARGE GENERATOR OPTION Present Value(PV) of Cash Flow= Cash flow/((1+i)^N) i= discount rate=Cost of capital=9%=0.09 N=Year of cash flow Year wise cash flow and PV of cash flows given below: Immediate Cash flow (Year0) ($280,000) Cash flow in year0 to 4 ($200,000) Total Cash flow in year0 (2800000+200000) ($480,000) N A B=A/(1.09^N) Year Cash flow PV of Cash Flow 0 ($480,000) -480000 1 ($200,000) -183486.2385 2 ($200,000) -168335.9987 3 ($200,000) -154436.696 4 ($200,000) -141685.0422 SUM -1127943.975 Net Present value for option of Large Generator $ (1,127,944) SMALL GENERATOR OPTION Present Value(PV) of Cash Flow= Cash flow/((1+i)^N) i= discount rate=Cost of capital=9%=0.09 N=Year of cash flow Year wise cash flow and PV of cash flows given below: Immediate Cash flow (Year0) ($140,000) Cash flow in year0 to 4 ($220,000) Total Cash flow in year0 (2800000+200000) ($360,000) N A B=A/(1.09^N) Year Cash flow PV of Cash Flow 0 ($360,000) -360000 1 ($220,000) -201834.8624 2 ($220,000) -185169.5985 3 ($220,000) -169880.3656 4 ($220,000) -155853.5464 SUM -1072738.373 Net Present value for option of Small Generator $ (1,072,738) Net Present Value of more attractive option $ (1,072,738) More Attractive option Small Generator OPTION A:DO NOT JOIN BUSINESS SCHOOL Present Value(PV) of Cash Flow= Cash flow/((1+i)^N) i= discount rate=11%=0.11 N=Year of cash flow Year wise cash flow and PV of cash flows given below: Immediate Cash flow (Year0) $50,000 Cash flow in year1 $56,000 (1.12*50000) Cash flow in year(N+1)=1.12*(Cash flow in year (N)) N A PV=A/(1.11^N) YEAR Cash flow PV of cash flow 0 $50,000 $ 50,000 1 $56,000 $ 50,450 2 $62,720 $ 50,905 3 $70,246 $ 51,364 4 $78,676 $ 51,826 5 $88,117 $ 52,293 6 $98,691 $ 52,764 7 $110,534 $ 53,240 8 $123,798 $ 53,719 9 $138,654 $ 54,203 SUM $ 520,765 Net Present value=Sum of PV of Cash Flows $ 520,765 OPTION B:JOIN BUSINESS SCHOOL Year wise cash flow and PV of cash flows given below: Immediate Cash flow (Year0) ($45,000) Cash flow in year1 ($45,000) Cash flow in year2 $85,000 Cash flow in year3 $97,750 (85000*1.15) Cash flow in year(N+1)=1.15*(Cash flow in year (N)) N>2 N A PV=A/(1.11^N) YEAR Cash flow PV of cash flow 0 ($45,000) $ (45,000) 1 ($45,000) $ (40,541) 2 $85,000 $ 68,988 3 $97,750 $ 71,474 4 $112,413 $ 74,050 5 $129,274 $ 76,718 6 $148,666 $ 79,483 7 $170,965 $ 82,347 8 $196,610 $ 85,314 9 $226,102 $ 88,389 SUM $ 541,222 Net Present value=Sum of PV of Cash Flows $ 541,222 More attractive choice: JOIN BUSINESS SCHOOL Net Present value of more attractive choice $ 541,222
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