Question

Wildhorse Incorporated management is considering investing in two alternative production systems. The systems are mutually exclusive, and the cost of the new equipment and the resulting cash flows are shown in the accompanying table. The firm uses a 10 percent discount rate for production system projects.

Year System 1 System 2

0 -$14,200 -$44,000

1 14,200 34,400

2 14,200 34,400

3 14,200 34,400

1) Calculate NPV. (Enter negative amounts using negative sign, e.g. -45.25. Do not round discount factors. Round answers to 2 decimal places, e.g. 15.25.)

NPV of System 1 is $_____ and NPV of System 2 is $______.

2) In which system should the firm invest?

The firm should invest in (System 1 or System 2).

Answer 1

Net Present Value (NPV) of SYTEM-1

Year	Annual cash flows ($)	Present Value factor at 10.00%	Present Value of Annual cash flows ($)
1	14,200	0.909091	12,909.09
2	14,200	0.826446	11,735.54
3	14,200	0.751315	10,668.67
TOTAL			35,313.30

Net Present Value (NPV) = Present Value of annual cash inflows – Initial Investment

= $35,313.30 - $14,200

= $35,313.30

Net Present Value (NPV) of SYTEM-2

Year	Annual cash flows ($)	Present Value factor at 10.00%	Present Value of Annual cash flows ($)
1	34,400	0.909091	31,272.73
2	34,400	0.826446	28,429.75
3	34,400	0.751315	25,845.23
TOTAL			85,547.71

Net Present Value (NPV) = Present Value of annual cash inflows – Initial Investment

= $85,547.71 - $44,000

= $41,547.71

DECISION

The firm should invest in SYSTEM-2, since it has the highest NPV of $41,547.71.

NOTE

The formula for calculating the Present Value Inflow Factor (PVIF) is [1 / (1 + r)ⁿ], where “r” is the Discount Rate/Cost of capital and “n” is the number of years.