Question

We can remodel our existing building at a cost of $6.9 million, or build a new building at a cost of $11 million. The old building, after it is refurbished, would not be as efficient as the new one, and energy costs would, therefore, be $750,000 a year higher. The maintenance cost for the old building would be $450,000 per year and $420,000 for the new building. The salvage value for the new building would be $3.25 million after its 15-year life, while the salvage value for the old building would be $1,800,000 after its 9-year life. In addition, the new building would allow our company to project a “Green Friendly” image that would result in better recruitment of clients and personnel. It is estimated that this “Green Friendly” image would result in cost savings or increased cash flows (after-tax) of $320,000 per year. If the new building is built, the old, the old building can be sold now for $850,000 in its present condition (please read pages 208-209 for the treatment of this cash flow). The required return for Boulder is 8 percent.

Net present value for keeping the old building_____________ Equivalent annuity for keeping the old building_________

Net present value for building a new building____________ Equivalent annuity for building a new building_________

Which option should be chosen? _______________

Answer 1

All cash flows should be discounted to present value using the discounting factors (here,8%) to find the Net present value(NPV). Since we have two options here, the one with highest NPV must be selected. Discounting factors for 10 years are given below:

Years	1	2	3	4	5	6	7	8	9	10	11	12	13	14	15
Discounting Factors	.926	.857	.794	.735	.681	.630	.583	.540	.500	.463	.429	.397	.368	.340	.315

[*Note= Discounting factor at the beginning of the year1 (assume year 0 or now) remains '1']

KEEPING THE OLD BUILDING

Years	0	1	2	3	4	5	6	7	8	9
Cost of remodelling	(6.9)
Energy cost	-	(.75)	(.75)	(.75)	(.75)	(.75)	(.75)	(.75)	(.75)	(.75)
Maintenance	-	(.45)	(.45)	(.45)	(.45)	(.45)	(.45)	(.45)	(.45)	(.45)
Salvage										1.8
Net cash flow	(6.9)	(1.2)	(1.2)	(1.2)	(1.2)	(1.2)	(1.2)	(1.2)	(1.2)	0.6
Discounting factor	1	.926	.857	.794	.735	.681	.630	.583	.540	.500
Present Value	(6.9)	(1.1112)	(1.0284)	(.9528)	(.882)	(.8172)	(.756).	(.6996)	(.648)	.3

NPV=(13.4952)

BUILDING NEW BUILDING

Years	0	1	2	3	4	5	6	7	8	9	10	11	12	13	14	15
Building cost	(11)
Maintenance	-	(.42)	(.42)	(.42)	(.42)	(.42)	(.42)	(.42)	(.42)	(.42)	(.42)	(.42)	(.42)	(.42)	(.42)	(.42)
Salvage																3.25
Incresed cash flow		.32	.32	.32	.32	.32	.32	.32	.32	.32	.32	.32	.32	.32	.32	.32
Net cash flow	(11)	(.1)	(.1)	(.1)	(.1)	(.1)	(.1)	(.1)	(.1)	(.1)	(.1)	(.1)	(.1)	(.1)	(.1)	3.15
Discounting Factor	1	.926	.857	.794	.735	.681	.630	.583	.540	.500	.463	.429	.397	.368	.340	.315
Present value	(11)	(.0926)	(.0857)	(.0794)	(.0735)	(.0681)	(.063)	(.06583)	(.054)	(.05)	(.0463)	(.0429)	(.0397)	(.0368)	(.034)	(.99225)

NPV=(10.3821)

Including the sale amount of old building,

NPV=(9.5321)

Since building new building gives the highest NPV ,that should be selected