Scopelli Manufacturing Company (SMC) is considering two mutually exclusive proje
ID: 2782739 • Letter: S
Question
Scopelli Manufacturing Company (SMC) is considering two mutually exclusive projects. The expected life of project L is six years and that of project K is three years. SMC is planning to repeat project K for another three years. The expected cash inflows and outflows are provided as follows:
Project K
Project L
Year
Cash Flow
Year
Cash Flow
0
($25,000)
0
($30,000)
1
20,000
1
25,000
2
20,000
2
25,000
3
20,000
3
25,000
4
25,000
5
25,000
6
25,000
SMC uses a weighted average cost of capital of 12% for both projects.
Which project do you advise the SMC to pick using NPV, without adjustment for their life difference?
To adjust for their life difference, you use the replacement chain and Equivalent Annual Annuity (EAA). Which project do you advise the SMC to pick now? You must explain how you get the solutions, step by step, in writing in 6 lines.
Project K
Project L
Year
Cash Flow
Year
Cash Flow
0
($25,000)
0
($30,000)
1
20,000
1
25,000
2
20,000
2
25,000
3
20,000
3
25,000
4
25,000
5
25,000
6
25,000
Explanation / Answer
On a financial calculator or excel, NPV can be calculated using NPV function
For K, CF0 = -25,000, CF1 = CF2 = CF3 = 20,000, I/Y = 12% => Compute NPV = 23,036.63
For L, CF0 = -30,000, CF1 = CF2 ...CF6 = 25,000, I/Y = 12% => Compute NPV = 72,785.18
Hence, purely based on NPV, we select Project L
EAA can be calculated using PMT function
For K, N = 3, I/Y = 12%, PV = 23,036.63, FV = 0 => Compute PMT = $9,591.28
For L, N = 6, I/Y = 12%, PV = 72,785.18, FV = 0 => Compute PMT = $17,703.23
We should still prefer Project L as it offers higher EAA.
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