Question

A firm that purchases electricity from the local utility for $400,000 per year is considering installing a steam generator at a cost of $310,000. The cost of operating this generator would be $260,000 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 9%. 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? Please round your answer to the nearest dollar. Report the NPV of cost as a negative number.

Answer 1

Option 1:

Purchasing Electricity from utility:

Purchase cost per year = $400000

NPV = -400000 * [PVAF (5-1, 9%) + 1]

= -400000 * [3.23972 + 1]

= -1695888

Option 2:

Purchasing generator:

Initial Cash Flow:

Purchase Cost of generator                                                                         -$310000

Operating Cash Flow                                                                                      -$260000

                                                                                                                                -$570000

Recurring Cash Flows:

Operating Cost                                                                                                                 -$260000

NPV:

Year	Cash Flow	PVF (9%)	PV of Cash Flow
0	-$570000	1	-$570000
1-4	-$260000	3.23972	-$842327
			-$1412327

NPV = -$1412327

Since NPV in case of purchasing generator is more than that of purchasing electricity,

NPV of more attractive alternative = NPV of purchasing generator = -$1412327