Question

The Oman National Grid Company ventures to a new project in the southern part of the Sultanate which is a 250-kilometer, 132 kilovolts transmission lines. The company has to choose between an Overhead transmission system and Underground transmission system. Table Q2 shows the initial investment for each type, the expected revenues during its lifetime which includes the cost savings incurred by underground transmission system over the overhead transmission system. The company has estimated a salvage value for each type of transmission to be 5% of the initial investment. As a company policy the minimum attractive rate of return MARR is 8% per year. Determine which of the two alternatives is acceptable to the company using the following methods; (i) Simple payback period; [7] (ii) Benefit cost ratio; [6] (ii) Net present value NPV; [6] (iii) Internal rate of return IRR

Items	Overhead	Underground Transmission
	Transmission	System
	System
Initial Investment	9,993	11,722
(million OMR)
Annual revenue + cost savings	980	1238
(million OMR)
Annual Operating & Maintenance O&M Cost/Depreciation/	256	181
taxes
(million OMR)
Life expectancy, n	40	30
(years)

Answer 1

Method	Preferred System
Payback Method	Underground Transmission
Cost-Benefit Ratio	Overhead System
NPV	Overhead System
IRR	Underground Transmission

(1)Simple Payback Period:

Solution - Choose Underground Transmission

Explanation:

Items	Overhead System	Underground Transmission
Initial Investment (C)	-9,993	-11,722
Annual revenue + cost savings	980	1238
Annual Operating & Maintenance O&M Cost/Depreciation/taxes	-256	-181
Net Cash Inflow/year (A)	724	1057
Life expectancy, n years	40	30
Salvage Value (S)	499.65	586.1

Items	Overhead System		Underground Transmission
	Cash Outlays	Cumulative	Cash Outlays	Cumulative
Initial Investment (Year 0)	-9,993	-9,993	-11,722	-11,722
Year 1	724	-9,269	1057	-10,665
Year 2	724	-8,545	1057	-9,608
Year 3	724	-7,821	1057	-8,551
Year 4	724	-7,097	1057	-7,494
Year 5	724	-6,373	1057	-6,437
Year 6	724	-5,649	1057	-5,380
Year 7	724	-4,925	1057	-4,323
Year 8	724	-4,201	1057	-3,266
Year 9	724	-3,477	1057	-2,209
Year 10	724	-2,753	1057	-1,152
Year 11	724	-2,029	1057	-95
Year 12	724	-1,305	1057	962
Year 13	724	-581	1057	2,019
Year 14	724	143	1057	3,076
Payback Period		13.80		10.91

Based on the payback period we have to choose the project with less payback period:

So we have to choose the Underground Transmission

2. Benefit-Cost Ratio

Solution - Choose Overhead System

Explanation:

Based on Benefit-Cost Ratio we have to choose the project with higher Benefit-Cost Ratio

PV of an Annuity = A x [ (1 – (1+i)^-n) / i ]

PV including the Salvage Value is given by A x [ (1 – (1+i)^-n) / i ] + S/(1+r)ⁿ  

Cost-Benefit Ratio = (A x [ (1 – (1+i)^-n) / i ] + S/(1+r)ⁿ )/C

C = initial investment (outflows)

Here C = Annual net cash flows (inflows)

Here n = useful life in years

r= interest rate = 0.08 or 8%

S = Salvage value

Substituting the values in the above formula we get

Benefit-Cost Ratio for Overhead System is 1.26

Benefit-Cost Ratio for Underground Transmission is 1.02

So we have to choose Choose Overhead System

3. NPV Method

Solution - Choose Overhead System

Explanation:

Based on the NPV method we have to choose the project with higher NPV

PV of an Annuity = A x [ (1 – (1+i)^-n) / i ]

PV including the Salvage Value is given by A x [ (1 – (1+i)^-n) / i ] + S/(1+r)ⁿ  

Now NPV = A x [ (1 – (1+i)^-n) / i ] + S/(1+r)ⁿ   - C

C = initial investment (outflows)

Here C = Annual net cash flows (inflows)

Here n = useful life in years

r= interest rate = 0.08 or 8%

S = Salvage value

Substituting the values in the above formula we get

NPV for Overhead System is 2634

NPV for Underground Transmission is 236

So we have to choose the Overhead System

4. IRR Method

Solution - Choose Underground Transmission

Explanation:

Based on the IRR method we have to choose the project with higher IRR value

The internal rate of return can be defined as that rate which equates the present value of cash inflows with the present value of cash outflows of an investment.

It can be determined by solving the following equation:

C= A₁/(1+r) + A₂ /(1+r)² + A₃ /(1+r)² +…….+ A_n /(1+r)ⁿ- S /(1+r)ⁿ

Calculating using Excel we get

IRR for Overhead System is 6.74%

IRR for Underground Transmission is 8.21%

So we have to choose the Underground Transmission