Two competing companies have submitted bids to develop a new video display techn

Question

Two competing companies have submitted bids to develop a new video display technology. The yearly development cost of Alpha expressed in actual dollars will be $150,000 the first year and increase by 5% per year over the five year contract. Beta has proposed a development cost, expressed in constant dollars, of $150,000 per year over the five year period. If the corporate MARR (investment at market rate) is 25% and the general price inflation is assumed to be 3.5% over the next five years, what is the NPW of Beta minus the NPW of Alpha?

Explanation / Answer

The calculation can be done by discounting constant dollars with real rate of interest (inflation excluded) or actual dollars discounted with market rate.

Note: The real rate of interest = [(1 + Nominal rate of interest)/(1 + inflation rate)] - 1 = (1.25/1.035) - 1 = 0.2077 = 20.77%

Current dollar cost analysis: NPW of Alpha: 1 2 3 4 5 Development cost (actual dollars) 150000 157500 165375 173644 182326 pvif @ 25% 0.8000 0.6400 0.5120 0.4096 0.3277 PV 120000 100800 84672 71124 59745 NPW = 436341 NPW of Beta: Development cost (constant dollars) 150000 150000 150000 150000 150000 Development cost (actual dollars) 155250 160684 166308 172128 178153 pvif @ 25% 0.8000 0.6400 0.5120 0.4096 0.3277 PV 124200 102838 85150 70504 58377 NPW = 441068 NPW of Beta - NPW of Alpha = 441068 - 436341 = 4727 $ Constant dollar cost analysis: NPW of Alpha: 1 2 3 4 5 Development cost (actual dollars) 150000 157500 165375 173644 182326 Development cost (constant dollars) 144928 147028 149159 151320 153514 pvif @ 20.77% 0.8280 0.6856 0.5677 0.4701 0.3892 PV 120003 100805 84678 71131 59752 NPW = 436369 NPW of Beta: Development cost (constant dollars) 150000 150000 150000 150000 150000 pvif @ 20.77% 0.8280 0.6856 0.5677 0.4701 0.3892 PV 124203 102843 85156 70511 58384 NPW = 441096 NPW of Beta - NPW of Alpha = 441096 - 436369 = 4727 $

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