Question

A firm that purchases electricity from the local utility for $350,000 per year is considering installing a steam generator at a cost of $270,000. The cost of operating this generator would be $270,000 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 13%. 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

NPV of project ,

Here Cn = Cash flow at n th Year

r = Cost of Capital = 13% = 0.13

n -1 has take as factoring (Where n denotes  n th Year) because cash flow happens at starting of the Year. ( If it happens at end of the year we would consider factor only n)

Now for Project Steam Generator

Cash Flow Using Steam Generator :

For Year 01 Cash Flow = Installation Cost + Operating Cost = 270,000 + 270,000 = 540,000

(-Ve Sign in table indicates Cost)

For Year 02 to Year 05 Cash Flow = Operating Cost = 270,000

Cash Flow Purchasing from local utility

Cost of purchasing  electricity from the local utility = $350,000 each year

So NPV Using Steam Generator = - 13,43,107 (Ans)

NPV Using Purchasing from local utility = - 13,91,065 (Ans)

So more attractive choice will be Using Steam Generator and its NPV - 13,43,107   (Ans)