The Smith Pie Company is considering two mutually exclusive investments that would increase its capacity to make strawberry tarts. The firm uses a 12 percent cost of capital to evaluate potential investments. The two projects have the following costs and expected cash flow streams:
|
Year
|
Alternative A
|
Alternative B
|
Year
|
Alternative A Alternative B
|
|
0
|
-$30,000
|
-$30,000
|
5
|
- $6,500
|
|
1
|
10,500
|
6,500
|
6
|
- 6,500
|
|
2
|
10,500
|
6,500
|
7
|
- 6,500
|
|
3
|
10,500
|
6,500
|
8
|
- 6,500
|
| 4 |
10,500 |
6,500 |
|
|
a. Using these data, calculate the net present value for Projects A and B.
b. Create a replacement chain for Alternative A. Assume that the cost of replacing A will be $30,000 and that the replacement project will generate cash flows of $10,500 for years 5 through 8. Using these figures, recompute the net present value for Alternative A.
c. Which of the two alternatives should be chosen, A or B? Why?
d. Use the equivalent annual annuity method to solve this problem. How does your answer compare with the one obtained in part b?