In an unrelated analysis, you have the opportunity to choose between the following two mutually exclusive projects, Project T (which lasts for two years) and Project F (which lasts for four years):
Expected Net Cash Flows
Year Project T Project F
0 ($100,000) ($100,000)
1 65,000 36,000
2 65,000 36,000
3 — 36,000
4 — 36,000
The projects provide a necessary service, so whichever one is selected is expected to be repeated into the foreseeable future. Both projects have a 11% cost of capital.
1. What is each project’s initial NPV without replication?
2. What is each project’s equivalent annual annuity?
3. Now apply the replacement chain approach to determine the projects’ extended NPVs. Which project should be chosen?
4. Now assume that the cost to replicate Project T in 2 years will increase to $105,000 because of inflationary pressures. How should the analysis be handled now, and which project should be chosen?
5. 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:
Initial Investment End-of-Year
And Operating Net Salvage
Year Cash Flows Value
0 ($5,000) $5,000
1 2,300 3,100
2 1,900 2,000
3 1,750 0
Using the 7% 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?