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.

I posted this question this morning and received the wrong answer. Please show me the answer for both NPV. So that I can check my own work.

Answer 1

There are 2 cases in the question above. We need to choose the one whose NPV of the cost is least (i.e. the project which is less costly).

Case 1: Purchasing electricity from the local utility for $300,000 per year

The NPV of the costs for 5 years can be calculated as:

= $300,000 + $270,270 + $243,487 + $219,357 + $197,619
= -$1,230,733 (negative as it is a cost)

Case 2: Installing the steam generator at a cost of $260,000with the cost of operating $210,000 per year

= $260,000 + $210,000 + $189,189 + $170,441 + $153,550 + $138,334
= -$1,121,514 (negative as it is a cost)

As the NPV of costs in Case 2 ($ 1,121,514) is less than that in Case 1 ($ 1,230,733), we should go with the case 2 (Installing the steam generator at a cost of $260,000with the cost of operating $210,000 per year) as it proves to be less costly.

The net present value of the more attractive choice is -$1,121,514.