Question

The Tempo Golf and Country Club in London, Ontario, is evaluating two different irrigation system options. An underground automatic irrigation system will cost $9.2 million to install and $80,000 pre-tax annually to operate. It will not have to be replaced for 20 years. An aboveground system will cost $6.8 million to install, but $190,000 per year to operate. The aboveground equipment has an effective operating life of nine years. The country club leases its land from the city and both systems are considered leasehold improvements; as a result, straight-line capital cost allowance is used throughout, and neither system has any salvage value. Which method should we select if we use a 13 percent discount rate?

Answer 1

The Net Present Value (NPV) method is used to evaluate the two irrigation system options. Calculating the NPV involves discounting the cash flows at the given discount rate and subtracting the initial investment. The option with the higher NPV is the more financially favorable choice. Therefore, the selection depends on which system has the higher NPV.

Step-by-step explanation:

For the underground automatic irrigation system, the annual cash flow is the pre-tax operating cost, which is $80,000 for 20 years. The NPV can be calculated using the formula:

`\[ NPV_{\text{underground}} = -\text{\textdollar}9,200,000 + \sum_(t=1)^(20) \frac{\text{\textdollar}80,000}{(1 + 0.13)^t} \]`

Similarly, for the aboveground system, the annual cash flow is the pre-tax operating cost, which is $190,000 for 9 years. The NPV is calculated as:

`\[ NPV_{\text{aboveground}} = -\text{\textdollar}6,800,000 + \sum_(t=1)^(9) \frac{\text{\textdollar}190,000}{(1 + 0.13)^t} \]`

Compute both NPVs, and the option with the higher NPV is the more financially viable choice for the Tempo Golf and Country Club. This analysis considers the time value of money and the club's cost of capital.