Question

Walker & Campsey wants to invest in a new computer system, and management has narrowed the choice to Systems A and B. System A requires an up-front cost of $125,000, after which it generates positive after-tax cash flows of $80,000 at the end of each of the next 2 years. The system could be replaced every 2 years, and the cash inflows and outflows would remain the same. System B also requires an up-front cost of $125,000, after which it would generate positive after-tax cash flows of $60,000 at the end of each of the next 3 years. System B can be replaced every 3 years, but each time the system is replaced, both the cash outflows and cash inflows would increase by 5%. The company needs a computer system for 6 years, after which the current owners plan to retire and liquidate the firm. The company's cost of capital is 12%. What is the NPV (on a 6-year extended basis) of the system that adds the most value?

Answer 1

System B is better with a higher NPV at $32,711.91

The NPVs are

	System A	System B
NPV	24823.59	32711.91

WORKINGS

The Cash flows are as follows

	Cash flow
Year	System A	System B
0	-125000	-125000
1	80000	60000
2	-45000	60000
3	80000	-65000
4	-45000	60000
5	80000	60000
6	80000	60000

NPV iscomputed using the NPV function in excel. It can also be computed using the formula

NPV= C0+ CF1/(1+r)^1 + CF2/(1+r)^2 …………CFn/(1+r)^n