Problem related to capital budgeting


Problem:

Borden Books is interested in purchasing a computer system to use for the next 10 years. Currently, Borden is considering two mutually exclusive systems, System S and System L.

System S has an up-front cost of $3 million at t = 0 and will produce positive cash flows of $2.5 million per year for two years (at t = 1 and 2). This system can be repeated forever. In other words, every two years the company can repurchase the system under exactly the same terms.

System L has an up-front cost of $5 million at t = 0 and will produce positive cash flows of $2 million per year for five years (at t = 1, 2, 3, 4, and 5). This system can be replaced at a cost of $4 million at t = 5, after which time it will produce positive cash flows of $1.5 million per year for the subsequent five years (at t = 6, 7, 8, 9, and 10).

Borden's CFO has determined that the company's WACC is 12 percent. Over a 10-year extended basis, which system is the better system and what is its NPV?

A.System L; $2.21 million

B.System L; $3.01 million

C.System S; $4.10 million

D.System L; $4.41 million

E.System S; $6.13 million

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Finance Basics: Problem related to capital budgeting
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