Question

Managers at Acme Doohickey Co. are considering two projects. Project A: purchase and operation of a new machine, called the Starpunch, for manufacturing Acme doohickeys. The life of this project is three years. Project B: purchase and operation of a new machine, called the Sunspot, for manufacturing Acme doohickeys. The life of this project is two years. The machines have identical capacity and produce the same doohickey. The company only has floor space in its machinists’ shop for one machine. Assume that the appropriate discount rate in 7%, compounded annually. Identify which project, if either, managers should accept, and explain why. Table: Expected Cash Flows for Projects A and B Year A revenue A costs A NCF B revenue B costs B NCF 0 ($29,000) ($23,000) 1 $20,000 ($9,000) $20,000 ($7,000) 2 $20,000 ($8,000) $20,000 ($6,000) 3 $20,000 ($8,000) Note: the table lists net revenue and net cost for each project and each year. But the table is incomplete; you will need to calculate the Net Cash Flows. Group of answer choices Accept Project B. Its NPV > 0. Also, when both of the project lifetimes are correctly extended to 6 years, the Project B NPV = $3,632 which is greater than the Project A NPV = $2,828. Accept Project A. Its NPV > 0. Also, when both of the project lifetimes are correctly extended to 6 years, the Project A NPV = $1,557 which is greater than the Project B NPV = $1,378. Accept Project B. Its NPV > 0. Also, when both of the project lifetimes are correctly extended to 6 years, the Project B NPV = $4,624 which is greater than the Project A NPV = $3,923. Reject both projects. When both of the project lifetimes are correctly extended to 6 years, the NPV for each project is negative. Accept Project B. Its NPV > 0. In addition, its cost in each year is less than the corresponding cost for Project A.

Answer 1

NCF calculation:

NPV = sum of discounted net cash flows

NPV of A = -29,000 + 11,000/(1+7%) + 12,000/(1+7%)^2 + 12,000/(1+7%)^3 = 1,557

NPV of B = -23,000 + 13,000/(1+7%) + 14,000/(1+7%)^2 = 1,378

If project life is increased to 6 years for both A and B then for A, the same cash flows will repeat for the Years 3-6. For B, the same cash flows will repeat for the Years 2-4 and then, again for the Years 4-6.

NCF calculation for A:

Year 0 NCF = -29,000; Year 1 NCF = 11,000; Year 2 NCF = 12,000; Year 3 NCF = 12,000 + investment = 12,000-29,000 = -13,000; Year 4 NCF = 11,000; Year 5 NCF = 12,000; Year 6 NCF = 12,000

NPV for A = -29,000 + 11,000/(1+7%) + 12,000/(1+7%)^2 - 13,000/(1+7%)^3 + 11,000/(1+7%)^4 + 12,000/(1+7%)^5 + 12,000/(1+7%)^6 = 2,828

NCF calculation for B:

Year 0 NCF = -23,000; Year 1 NCF = 13,000; Year 2 NCF = 14,000 + investment = 14,000 -23,000 = -9,000; Year 3 NCF = 13,000; Year 4 NCF = 14,000 + investment = 14,000-23,000 = -9,000; Year 5 NCF = 13,000; Year 6 NCF = 14,000

NPV for B = -23,000 + 13,000/(1+7%) - 9,000/(1+7%)^2 + 13,000/(1+7%)^3 - 9,000/(1+7%)^4 + 13,000/(1+7%)^5 + 14,000/(1+7%)^6 = 3,632

The correct option is:

Accept Project B. Its NPV > 0. Also, when both of the project lifetimes are correctly extended to 6 years, the Project B NPV = $3,632 which is greater than the Project A NPV = $2,828