Question

Cannibus Imports Inc. is considering a service contract for its maintenance work. One firm has offered a four-year contract for $215,000 up front, while another firm has offered a six-year contract for $340,000 up front.   The firm will be able to save $81,000 per year under either contract because its employees will no longer have to do the work themselves.

a. If the firm's cost of capital is 6%, which project should be selected? Show NPV and EAA capital budgeting techniques. Justify your answer using the most appropriate of these techniques.

b.   If the firm's cost of capital is 4%, does it change the decision?

K м N O P Q R CFO CF1 CF2 Project A (215,000) 81,000 81,000 81,000 81,000 CFO CF CF2 Project B (340,000) 81,000 81,000 81,000 81,000 81,000 81,000 CF3 CF3 CF4 CF4 CF5 CF5 CF6 CF6 29 a) 6.0% Project A 4.0% Project A Project B Project B 31 32 NPV n= EAA (PMT) = Decision: NPV n = EAA (PMT) = Decision: 34 35

Please show calculation, thank you.

Answer 1

Part-a:

Project-A:
Year	Cash Flows	DF Working	Discounting Factor @ 6%	Present Value
0	(215,000)	1	1	(215,000.00)
1	81,000	1/1.06^1	0.943396226	76,415.09
2	81,000	1/1.06^2	0.88999644	72,089.71
3	81,000	1/1.06^3	0.839619283	68,009.16
4	81,000	1/1.06^4	0.792093663	64,159.59
			NPV:(1)	65,673.55
			PVIFA(6%,4): (2)	3.4651
			EAA (PMT): (3) = (1)/(2)	18,952.83
Project-B:
Year	Cash Flows	DF Working	Discounting Factor @ 6%	Present Value
0	(340,000)	1	1	(340,000.00)
1	81,000	1/1.06^1	0.943396226	76,415.09
2	81,000	1/1.06^2	0.88999644	72,089.71
3	81,000	1/1.06^3	0.839619283	68,009.16
4	81,000	1/1.06^4	0.792093663	64,159.59
5	81,000	1/1.06^5	0.747258173	60,527.91
6	81,000	1/1.06^6	0.70496054	57,101.80
			NPV: (1)	58,303.27
			PVIFA(6%,6): (2)	4.9173
			EAA (PMT) : (3) = (1)/(2)	11,856.71

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Project -A should be selected since it has positive NPV and higher positive EAA .

.

.

Part-b:

Project-A:
Year	Cash Flows	DF Working	Discounting Factor @ 4%	Present Value
0	(215,000)	1	1	(215,000.00)
1	81,000	1/1.04^1	0.961538462	77,884.62
2	81,000	1/1.04^2	0.924556213	74,889.05
3	81,000	1/1.04^3	0.888996359	72,008.71
4	81,000	1/1.04^4	0.854804191	69,239.14
			NPV:(1)	79,021.51
			PVIFA(6%,4): (2)	3.6299
			EAA (PMT): (3) = (1)/(2)	21,769.64
Project-B:
Year	Cash Flows	DF Working	Discounting Factor @ 6%	Present Value
0	(340,000)	1	1	(340,000.00)
1	81,000	1/1.04^1	0.961538462	77,884.62
2	81,000	1/1.04^2	0.924556213	74,889.05
3	81,000	1/1.04^3	0.888996359	72,008.71
4	81,000	1/1.04^4	0.854804191	69,239.14
5	81,000	1/1.04^5	0.821927107	66,576.10
6	81,000	1/1.04^6	0.790314526	64,015.48
			NPV: (1)	84,613.09
			PVIFA(6%,6): (2)	5.2421
			EAA (PMT) : (3) = (1)/(2)	16,140.95

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If firm's cost of capital is 4%. Project -B will be selected as it has higher NPV.