Edison Systems has estimated the cash flows over the 5-year lives for two projec

Question

Edison Systems has estimated the cash flows over the 5-year lives for two projects, A and B. These cash flows are summarized in the table below. a. If project A were actually a replacement for project B and if the $12,000 initial investment shown for project B were the after-tax cash inflow expected from liquidating it, what would be the relevant cash flows for this replacement decision? b. How can an expansion decision such as project A be viewed as a special form of a replacement decision? Explain. Initial investment / Project A = $40,000 / Project B = $12,000* Year / Operating cash inflows 1 $10,000 // $ 6,000 2 12,000 // 6,000 3 14,000 // 6,000 4 16,000 // 6,000 5 10,000 // 6,000 *After-tax cash inflow expected from liquidation.

Explanation / Answer

Is there a cost of capital (interest rate) in the problem which you did not disclose? Normally a question like this would contain a discount rate (cost of capital). if there is no discount rate: A: -$40,000(investment) +10,000+12,000+14,000+16,000+10,000 = $22,000 B: -$12,000(investment) + $6,000 + 6,000 + 6,000 +6000 + 6,000 = $18,000 accept both projects because the cash flows from both project are positive.) If the projects are mutually exclusive (can only accept one project), choose project A. If project A was a replacement for project B, the relevant cash flows for the replacement decision would only include the cash flows from Project B because the $12,000 cash flow from liquidating A would occur whether project B is undertaken or not. hope this helps.

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