Question

Walker & Campsey wants to invest in a new computer system, and management has narrowed the choice to Systems A and B.

System A requires an up-front cost of $125,000, after which it generates positive after-tax cash flows of $80,000 at the end of each of the next 2 years. The system could be replaced every 2 years, and the cash inflows and outflows would remain the same.

System B also requires an up-front cost of $125,000, after which it would generate positive after-tax cash flows of $60,000 at the end of each of the next 3 years. System B can be replaced every 3 years, but each time the system is replaced, both the cash outflows and cash inflows would increase by 5%.

The company needs a computer system for 6 years, after which the current owners plan to retire and liquidate the firm. The company's cost of capital is 12%. What is the NPV (on a 6-year extended basis) of the system that adds the most value?

Using the information from the problem on Walker & Campsey, what is the equivalent annual annuity (EAA) for System B? Enter your answer rounded to two decimal places.

Answer 1

		Present Value (PV) of Cash Flow:
		(Cash Flow)/((1+i)^N)
		i=Discount Rate=Cost of Capital=12%	0.12
		N=Year of Cash Flow
		CASH FLOWS OF SYSTEM    A
	N	Year	0	1	2	3	4	5	6
	A	Cashflows for the Initial investment	($125,000)	$80,000	$80,000
	B	Cashflows for the First Replacement			($125,000)	$80,000	$80,000
	C	Cashflows for the Second Replacement					($125,000)	$80,000	$80,000
	D=A+B+C	Net Cash Flow	($125,000)	$80,000	($45,000)	$80,000	($45,000)	$80,000	$80,000	SUM
	PV=D/(1.12^N)	Present Value (PV) of Cash Flow:	($125,000)	$71,429	-$35,874	$56,942	-$28,598	$45,394	$40,530	$24,824
	NPV=sumof PVs	Net Present Value(NPV) of System A	$24,824
		CASH FLOWS OF SYSTEM    B
		Cash Flows of first Replacement:
		Outflow=125000*1.05	$131,250
		Inflows =60000*1.05	$63,000
	N	Year	0	1	2	3	4	5	6
	A	Cashflows for the Initial   investment	($125,000)	$60,000	$60,000	$60,000
	B	Cashflows for the Replacement				($131,250)	$63,000	$63,000	$63,000
	D=A+B	Net Cash Flow	($125,000)	$60,000	$60,000	($71,250)	$63,000	$63,000	$63,000	SUM
	PV=D/(1.12^N)	Present Value (PV) of Cash Flow:	($125,000)	$53,571	$47,832	-$50,714	$40,038	$35,748	$31,918	$33,392
	NPV=sumof PVs	Net Present Value(NPV) of System B	$33,392
		NPV of the Systemthat adds most value	$33,392	(SYSTEM B)
		Equivalent Annual Annuity (EAA)	$8,121.79	Using PMT function of excel with Rate=12%, Nper=6,Pv=-33392)
		Excel Command:PMT(12%,6,-33392)