Question

Question B [AR1: 5 Marks]

Sun Corporation is currently evaluating two mutually exclusive pollution control devices. The devices have differing initial costs, differing maintenance costs over their operational lives, and different operating lives. The real discount rate is 6%. The real cash flows for each device are as follows:

Time	Device A	Device B
0	($90,000)	($260,000)
1	($6,000)	($3,500)
2	($6,000)	($3,500)
3	($6,000)	($3,500)
4	---	($3,500)
5	---	($3,500)
6	---	($3,500)

Required:

a.	Discuss the problem in evaluating the two projects with the basic NPV.
b.	Evaluate the devices based on the use of comparable time horizons at the end of which both projects are complete.

Answer 1

a)	As the two projects have different lives, it would be inequitable
	to compare the projects with their normal NPVs, as the shorter lived
	project has a possibility of getting repeated after its useful life,
	thereby generating cash flows for more number of years which is
	not considered by normal NPV.
b)	For evaluating the projects on an even plane, the Device A should be
	repeated once at the EOY 3, so that its life would also be of 6 years.
	The NPV after repeating Device A is calculated below:
	Time	Device A	PVIF at 6%	PV at 6%	Device B	PV at 6%
	0	$           -90,000	1	$      -90,000	$ -2,60,000	$   -2,60,000
	1	$              -6,000	0.94340	$        -5,660	$        -3,500	$         -3,302
	2	$              -6,000	0.89000	$        -5,340	$        -3,500	$         -3,115
	3	$              -6,000	0.83962	$        -5,038	$        -3,500	$         -2,939
	4	$           -96,000	0.79209	$      -76,041	$        -3,500	$         -2,772
	5	$              -6,000	0.74726	$        -4,484	$        -3,500	$         -2,615
	6	$              -6,000	0.70496	$        -4,230	$        -3,500	$         -2,467
		$        -2,16,000		$ -1,90,792	$ -2,81,000	$   -2,77,211
	DECISION:
	As the PV of the cash outflows of Device A is lower, it should be chosen.