A firm that purchases electricity from the local utility is considering installi

Question

A firm that purchases electricity from the local utility is considering installing a steam generator. A large generator costs $260,000 whereas a small generator costs $120,000. The cost of operating the generator would be $250,000 per year for the large and $265,000 for the small. Either generator will last for five years. The cost of capital is 12%. For each 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 (i.e., immediate, one year from now, ..., four years from now). What is the net present value of the more attractive generator? Please round your answer to the nearest dollar. Report the NPV of cost as a negative number.

Explanation / Answer

The Cost of capital is12% which is used as discounting factor in the following calculation.

The small generator is more attractive as its NPV is - $ 1,189,898 (less costly) while the NPV of large generator is - $1,269,337

year Cash flow from large generator CF1 Formula PV of each cash flow cash flow from small generator CF2 Formula PV of each cash flow 0 -260,000 CF1/(1+12%)^0 -260000 -120,000 CF2/(1+12%)^0 -120000 0 -250,000 CF1/(1+12%)^0 -250000 -265,000 CF2/(1+12%)^0 -265000.00 1 -250,000 CF1/(1+12%)^1 -223214.2857 -265,000 CF2/(1+12%)^1 -236607.14 2 -250,000 CF1/(1+12%)^2 -199298.4694 -265,000 CF2/(1+12%)^2 -211256.38 3 -250,000 CF1/(1+12%)^3 -177945.062 -265,000 CF2/(1+12%)^3 -188621.77 4 -250,000 CF1/(1+12%)^4 -158879.5196 -265,000 CF2/(1+12%)^4 -168412.29 NPV ($1,269,337.34) ($1,189,897.58)

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