A company is considering two average-risk alternative ways of producing a produc

Question

A company is considering two average-risk alternative ways of producing a product. Process A has a cost of $8,500 and will produce net cash flows of $5,000 per year for 2 years. Process B will cost $11,500 and will produce cash flows of $4,000 per year for 4 years. The company can extend each of the two alternatives as needed. The cash inflows occur at the end of each year, and this company’s cost of capital is 9 percent. (please show work)

The company will use the replacement chain approach to evaluate the project, the NPV of the better project?

A.1748.51

B.1458.88

C.1566.87

Explanation / Answer

NPV of Project A = cash flow in each year/(1+cost of capital)^n where n is the year of cash flow

Thus NPV of A = -8500/1.09^0 + 5000/1.09^1 + 5000/1.09^2

= 295.56

NPV of Project B = -11500/1.09^0 + 4000/1.09^1 + 4000/1.09^2 + 4000/1.09^3 + 4000/1.09^4

= $1,458.88

As NPV of project B> NPV of project A we will select project B as it is the better project.

NPV of the better project i.e. project B (as computed above) = 1458.88

Hence answer is "B" - 1458.88

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