Question

Two energy saving project have been identified by Company ABC. These potential projects are known as project
A and 8 . The projects require different investments and costs as indicated in the Table below ..

Financial item	OPTION A (million)	OPTION B (million)
First cost	5000	700
Economic life in years	10	5
Salvage value	100	150
Annual operating costs	5	10
Major overhaul costs in year 5	20	0
Increase in annual operating costs from year and thereafter	1.5	2
Penalty costs due to environmental pollution	2 from year five and thereafter	1 annually from year 2 to 5 and thereafter
Savings in annual energy costs	250	300

Company ABC would like to know which project is worth pursuing. Use an internal rate of return method to
establish the most viable project

Answer 1

Cash flow = Savings in annual energy costs - first cost - annual operating cost - penalty cost - major overhaul cost + salvage value

Option A cash flows:

Year (n)	0	1	2	3	4	5	6	7	8	9	10
First cost	(5,000)
Savings in annual energy costs		250	250	250	250	250	250	250	250	250	250
Annual operating cost with increases		(5.00)	(6.50)	(8.00)	(9.50)	(11.00)	(12.50)	(14.00)	(15.50)	(17.00)	(18.50)
Penalty costs						(2)	(2)	(2)	(2)	(2)	(2)
Major overhaul costs						(20)
Salvage value											100
Cash flow (CF)	(5,000)	245	244	242	241	217	236	234	233	231	330
IRR	-10.98%

Option B cash flows:

Year (n)	0	1	2	3	4	5
First cost	(700)
Savings in annual energy costs		300	300	300	300	300
Annual operating cost with increases		(10.00)	(12.00)	(14.00)	(16.00)	(18.00)
Penalty costs			(1)	(1)	(1)	(1)
Salvage value						150
Cash flow (CF)	(700)	290	287	285	283	431
IRR	29.80%

IRR for project A = -10.98%

IRR for project B = 29.80%

Project B is the only viable project.

Note: It is not mentioned from year the annual operating costs are increasing. It has been assumed that operating costs start increasing from year 2 onwards.