Question

A firm that purchases electricity from the local utility for $350,000 per year is considering installing a steam generator at a cost of $270,000. The cost of operating this generator would be $270,000 per year, and the generator will last for five years. If the firm buys the generator, it does not need to purchase any electricity from the local utility. The cost of capital is 13%. For the local utility option, consider five years of electricity purchases. For the generator option, assume immediate installation, with purchase and operating costs in the current year and operating costs continuing for the next four years. Assume payments under both options at the start of each year (i.e., immediate, one year from now,..., four years from now). What is the net present value of the more attractive choice

Answer 1

Option 1:

Purchasing Electricity from the utility:

NPV = -$1391065.

Option 2:

NPV of more attractive alternative = NPV of purchasing generator = -$1343107.

Step-by-step explanation:

Option 1:

Purchasing Electricity from the utility:

Purchase cost per year = $350000

`NPV = -350000 * [PVAF (5-1, 0.13) + 1]\\= -350000 * [2.974471 + 1]\\\\= -1391064.85`

NPV = -$1391065.

Option 2:

Purchasing generator:

Initial Cash Flow:

Purchase Cost of generator -$270000

Operating Cash Flow -$270000

= -$540000

Recurring Cash Flows:

Operating Cost -$270000

NPV:

Year Cash Flow PVF (13%) PV of Cash Flow

0 -$540000 1 -$540000

1-4 -$270000 2.974471 -$803107

-$1343107

NPV = -$1343107

Since NPV in the case of purchasing a generator is more than that of purchasing electricity,

NPV of more attractive alternative = NPV of purchasing generator = -$1343107.