sufficient funds åre aali APPENDIX 2A.2 : MUTUALLY EXCLUSIVE PROJECTS WITH DIFFE
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Question
sufficient funds åre aali APPENDIX 2A.2 : MUTUALLY EXCLUSIVE PROJECTS WITH DIFFERENT ECONOMIC LIVES ESuppose a company is considering replacing One way to choose between these:m clusive investments is to compare t Dole or a new Daihatsu. Both trucks have the bresent values of their costs. Assuming a dis same capacity, but the Dole truck is sturdier countrat 1890, the PVs for each truck are than the Daiha expectancy is five years as opposed to fou years for the Daihatsu. In addition,the Dole's, annual operating costs of 3,000 are $1,000/ | a result, the Dole's life as follows: Dole $12,000 $3,000 $3,000 $3,000 $3,000 $3,000 Daihatsu $7,500 $4,000 $4,000 $4,000 $4,000 Year less than the Daihatsu's annual operating 0 costs of $4,000. However, the Daihatsu costs only $7,300, whereas the Dole costs $12,000. These data are summarized as follows Daihatsu truck $7,500 4 years Dole truck Initial cost Salvage value Life Operating cost $12,000 Present value $23,978.10 $20,740.40 5 years $3,000/year $4,000/year| | of cost at 8%Explanation / Answer
So you need help with computing the present value of costs discounted back at 8%.
We are already given the costs of both the trucks during their life terms, however, what complicates the NPV calculation is that the life of both the trucks is different.
In my opinion the best approach in such scenarios is that the costs should be viewed as the Equivalent Annual Costs (or the EAC approach).
To compute the EAC of any project, we take the total costs of the project and divide it by the sum of the discounting factors through the life of the project. In other words, for dole, the cost will be divided by the sum of PV discounting factors for year 1 to 5, while in case of Daihatsu, the costs will be divided by the sum of PV discounting factors for year 1 to 4.
Doing so would give us the following EAC for both the trucks:
As I mentioned, in Dole's case the PV Factor is upto the fifth year, while in Daihatsu's case this is upto the fourth year.
The EAC clearly distinguishes Dole as the more preferable choice!
Now with the concept out of the way, Let's explain the illustration for you.
As you can see the illustration only discounts the cash flows to year 0. It is yet to adjust the cash flows for the different life periods, which can only be done using the EAC approach mentioned above.
Hope that helps you out!
Don't forget to upvote! :)
Dole Daihatsu 0 12,000.00 7,500.00 1 3,000.00 4,000.00 2 3,000.00 4,000.00 3 3,000.00 4,000.00 4 3,000.00 4,000.00 5 3,000.00 - Total of Cash flows 27,000.00 23,500.00 PVF at 8% for life of the trucks 3.99271 3.3121268 EAC in $ 6,762.32 7,095.14Related Questions
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