Q7. Three mutually exclusive alternatives are being evaluated and their costs an
ID: 2822422 • Letter: Q
Question
Q7. Three mutually exclusive alternatives are being evaluated and their costs and revenues are listed in the following table Alt I Alt 11 Alt IIII Capital Investment Annual Revenues Annual Expenses Market Value Useful Life (vears $300,000 $200,000 $50,000 $50,000 10 $450,000 $100,000 $50,000 $50,000 10 $600,000 $200,000 $100,000 $100,000 10 1) If the MARR is 20% per year and the analysis period is 10 years, use the PW method to determine which alternatives are economically acceptable and which one should be selected(10 marks) 2) If the total capital investment budget available is $500,000, which alternative should be selected? (5 marks)Explanation / Answer
(a)
Alternative I:
Annual Revenue = $ 250000, Annual Expense = $ 50000
Net Income = 250000 - 50000 = $ 200000
Market Value (at project completion) = $ 50000
Capital Investment = $ 300000 and Project Tenure = 10 years
MARR = 20 %
PW of Market Value and Net Income = 200000 x (1/0.2) x [1-{1/(1.2)^(10)}] + 50000 / (1.2)^(10) = $ 846569.696
Net PW = 846569.696 - 300000 = $ 546569.696
Alternative II:
Annual Revenue = $ 100000, Annual Expense = $ 50000
Net Income = 100000 - 50000 = $ 50000
Market Value (at project completion) = $ 50000
Capital Investment = $ 450000 and Project Tenure = 10 years
MARR = 20 %
PW of Market Value and Net Income = 50000 x (1/0.2) x [1-{1/(1.2)^(10)}] + 50000 / (1.2)^(10) = $ 217698.883
Net PW = 217698.883 - 450000 = - $ 232301.117
Alternative III:
Annual Revenue = $ 200000, Annual Expense = $ 100000
Net Income = 200000 - 100000 = $ 100000
Market Value (at project completion) = $ 100000
Capital Investment = $ 600000 and Project Tenure = 10 years
MARR = 20 %
PW of Market Value and Net Income = 100000 x (1/0.2) x [1-{1/(1.2)^(10)}] + 100000 / (1.2)^(10) = $ 435397.767
Net PW = 435397.767 - 600000 = - $ 164602.233
As Alternative I is the only option that gives a positive NPW, the same is economically acceptable and should be chosen.
(b) Although the total capital investment budget is $ 500000, only one alternative generates value for the firm (has positive NPW) and therefore only Alternative 1 should be selected at a capital investment of $ 300000. The other two investments generate negative value (negative NPW) and should not be taken up even if the budget is available.
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