Question

A firm that purchases electricity from the local utility for $300,000 per year is considering installing a steam generator at a cost of $260,000. The cost of operating this generator would be $210,000 per year, and the generator will last for five years. If the firm buys the generator, it does not need to purchase any electricity from the local utility. The cost of capital is 11%.

For the local utility option, consider five years of electricity purchases. For the 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 choice?

Answer 1

Solution :

The NPV of the option to purchase electricity from the local utility = - $ 1,230,733.71

= - $ 1,230,734 ( when rounded off to the nearest whole number )

The NPV of the option to install a steam generator = - $ 1,121,513.59

= - $ 1,121,514 ( when rounded off to the nearest whole number )

The option to install steam generator is attractive as it has lower NPV = - $ 1,121,154

Note : Both the option do not have any cash inflows. Thus the NPV of both the options is the total of discounted cash outflows.

Please find the attached screenshot of the excel sheet containing the detailed calculation for the solution.