The Smith Pie Company is considering two mutually exclusive investments that wou

Question

The Smith Pie Company is considering two mutually exclusive investments that would increase its capacity to make strawberry tarts. The firm uses a 12 percent cost of capital to evaluate potential investments. The two projects have the following costs and cash flows streams: Alternative A Year 0 $-30,000 1 $10,500 2 $10,500 3 $10,500 4 $10,500 Alternative B Year 0 $-30,000 1 $6,500 2 $6,500 3 $6,500 4 $6,500 5 $6,500 6 $6,500 7 $6,500 8 $6,500 a. Using the data, calculate the net present value for Projects A and B. b.Create a replacement chain for Alternative A. Assume that the cost of replacing A will be $30,000 and that the replacement project will generate cash flows of $10,500 for years 5 through 8. Using these figures, recompute the net present value of Alternative A. c. Which of the two alternatives should be chosen, A or B? Why?

Explanation / Answer

Results may vary with your given answer based on discouting factor used. I have taken 4 digit factor for better accuracy Alternative A Alternative B a Year Discounting Factor @12% Cash Flow PV of Cash Flow Cash Flow PV of Cash Flow Year 0 1        (30,000)        (30,000)        (30,000)     (30,000) Year 1 0.89286          10,500             9,375            6,500          5,804 Year 2 0.79719          10,500             8,371            6,500          5,182 Year 3 0.71178          10,500             7,474            6,500          4,627 Year 4 0.63552          10,500             6,673            6,500          4,131 Year 5 0.56743            6,500          3,688 Year 6 0.50663            6,500          3,293 Year 7 0.45235            6,500          2,940 Year 8 0.40388            6,500          2,625 NPV A $         1,892 NPV B $     2,290 b Replacement Chain NPV for Alternative A Alternative A Year Discounting Factor @12% Cash Out flow Cash In flowFlow Net Cash Flow PV of Cash Flow Year 0 1        (30,000)        (30,000)     (30,000) Year 1 0.89286           10,500          10,500          9,375 Year 2 0.79719           10,500          10,500          8,371 Year 3 0.71178           10,500          10,500          7,474 Year 4 0.63552        (30,000)           10,500        (19,500)     (12,393) Year 5 0.56743           10,500          10,500          5,958 Year 6 0.50663           10,500          10,500          5,320 Year 7 0.45235           10,500          10,500          4,750 Year 8 0.40388           10,500          10,500          4,241 NPV A $     3,095 c. If we use normal NPV , then Alternative B should be used for higher NPV. But when we use replacement chain NPV for comparable analysis, Alternative A should be chosen for higher replacment chain NPV value.

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