Question

Year	Proj Y	Proj Z
0	($125,000)	($125,000)
1	100,000	50,000
2	85,000	52,500
3	—	63,000
4	—	75,000

The projects provide a necessary service, so whichever one is selected is expected to be repeated into the foreseeable future. Both projects have an 11% cost of capital.

6.   What is each project’s initial NPV without replication?

7.   What is each project’s equivalent annual annuity?

8.   Now apply the replacement chain approach to determine the shorter projects’ extended NPV. Which project should be chosen?

9.   Now assume that the cost to replicate Project Y in 2 years will increase to $140,000 because of inflationary pressures. How should the analysis be handled       now, and which project should be chosen?

10. You are also considering another project which has a physical life of 3 years; that is, the machinery will be totally worn out after 3 years. However, if the           project were terminated prior to the end of 3 years, the machinery would have a positive salvage value. Here are the project’s estimated cash flows:

       

Yr	CF	Salvage
0	($57,000)	$57,000
1	26,200	38,000
2	32,800	19,000
3	49,525	0

                 

                  Using the 12% cost of capital, what is the project’s NPV if it is operated for the full 3 years? Would the NPV change if the company planned to terminate the project at the end of Year 2? At the end of Year 1? What is the project’s optimal (economic) life?

Answer 1