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?

Please round your answer to the nearest dollar. Report the NPV of cost as a negative number.

Answer 1

Statement showing NPV of buying Steam generator

Particulars	0	1	2	3	4	NPV = sum of PV
Purchase cost of equipment	-260000
Cost of operating this generator	-210000	-210000	-210000	-210000	-210000
Total cash flow	-470000	-210000	-210000	-210000	-210000
PVIF @ 11%	1.0000	0.9009	0.8116	0.7312	0.6587
PV	-470000	-189189	-170441	-153550	-138334	-1121514

Thus NPV of  buying Steam generator = -1121514 $

Statement showing NPV of purchase of electricity

Particulars	0	1	2	3	4	NPV = sum of PV
Purchase of electricity	-300000	-300000	-300000	-300000	-300000
Total cash flow	-300000	-300000	-300000	-300000	-300000
PVIF @ 11%	1.0000	0.9009	0.8116	0.7312	0.6587
PV	-300000	-270270	-243487	-219357	-197619	-1230734

Thus NPV of purchase of electricity = - 1230734 $

Thus  net present value of the more attractive choice = NPV of buying Steam generator = -1121514 $