Question

Data for two mutually exclusive alternatives are given below.

	Alternative A	Alternative B
Initial Cost	$4,000	$3,000
Annual Benefits (beginning at the end of year 1)	$1,000	$600
Annual Costs (beginning at the end of year 1)	$300	$100
Salvage Value	$500	$0
Useful Life (years)	5	10

Compute the net present worth for each alternative and choose the better alternative. MARR = 6%

A. None can be chosen

B. Alternative A

C. Alternative B

D. Any alternative can be chosen

Answer 1

Calculation of net present worth for Alternative A

Note: The initial cost is $ 4,000 which is outflow at the beginning of year 1 (i.e. present value factor would be 1) and salvage value is $ 500 at the end of 5 years. Therefore, there will be two cash inflows at the end of year 5 which are

a. Net benefit = 1000 - 300 = 700 and

b. Salvage value = 500

Net benefit at the end of year 1 to year 5 = = 1000 - 300 = 700

Following is the net present value of Alternative A:

(Please note that outflow are represented by minos sign)

Therefore, net present value of Alternative A is negative which is - 678 i.e. there is net cash outflow.

Calculation of net present worth for Alternative B

Note: The initial cost is $ 3,000 which is outflow at the beginning of year 1 (i.e. present value factor would be 1) and salvage value at the end of year 10 would be Nil. Net benefit at the end of each year = 600 - 100 = 500

Following is the net present value of Alternative B:

(Please note that outflow are represented by minos sign)

Therefore, net present value of Alternative B is positive which is 680 i.e. there is net cash inflow.

Hence using present value method, it is clear that alternative B is better than alternative A and Alternative B can be selected since the net present value is positive.

Hence, the option C (Alternative B) is to be chosen.