3. A company must decide between 3 alternatives. First it will determine if each

Question

3. A company must decide between 3 alternatives. First it will determine if each makes sense as a single alternative, and if any project makes sense it will compare the appropriate projects using Annualized Cost. The projects will last 360 months. 1-6% per year Project A: Initial Cost300,000. Revenue is constant at 1000 per month month. Salvage Value of Equipment is 30,000 Costs are constant at 100 per Project B: Initial Cost 500,000. Revenue at t 1 is 200. The revenue increases each month by 300 per month. Costs can be considered O (negligible). Salvage Value is 10,000. Project C: Initial Cost 400,000. Revenue is constant at 1000 per month. Costs start at 80 per month at = 1 and increase each month by 30, Salvage Value is 3,000 Determine if each choice makes sense and compare any sensible single alternative choices using Annualized Worth

Explanation / Answer

Project 1:

NPV Calculation -

Initial Cash Outflow = -$300,000

Cash Inflow = Revenue - Cost = 1000 - 100 = 900 per month

Interest Rate = 6% = 0.5% per month

Duration = 360 months

NPV = -$149,887

Project 2:

NPV Calculation -

Initial Cash Outflow = -$500,000

Cash Inflow = 200 at t=1

Interest Rate = 6% = 0.5% per month

Duration = 360 months

Taking the PV of Revenue and Cost separately and adding to NPV calculation

PV of revenue 200 per month for (360 - 12) = 348 months since it will start at year =1

PVr = 32,949

PV of incremental revenue 300 per month for (360 - 13) = 347 months.

PVir = 49,370

NPV = -500,000 – (32,949+49,370) = -$417,681

Project 3:

NPV Calculation -

Initial Cash Outflow = -$400,000

Cash Inflow = 1000 per month for 360 months

PVr = 166,791

Cash Outflow = 80 per month for (360 - 12) = 348 months since it will start at year =1

PVc = -13,179

Incremental Cash Outflow = 30 per month for (360 - 12) = 348 months.

PVic = -4,937

NPV = -400,000 +166,791 – 13,179 – 4,937 = -$251,325

Since cost is incremental in nature, NPV will be further negetive if we add all incremental costs.

The project #2 will be the best choice since the NPV is upward trending towards positive direction due to incremental revenue. If we add all incremental revenue month after month it will reduce the negetive NPV value and push it towards positive direction.

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