Evaluate the net present value of the cash flows


Problem:

The State Power and Electricity Commission has branch offices in two country towns, Rundown and Brokendown. As well as providing customer account payment services, the offices also serve as bases for technicians who do repair and maintenance work on power lines and equipment in the area.

The Commission is considering closing down both these branch offices and building a new office at another town, Newtown. Newtown is halfway between Rundown and Brokendown and would be the base for customer and equipment maintenance services for all three towns.

Part of the reason for considering the move at this time is that both the existing branch offices are in very poor shape. If the commission decides to retain the existing locations, the offices at Rundown and Brokendown will both need some structural repair and extensive renovations. The Commission, therefore, has two alternatives. The first option is to retain the existing locations and carry out the renovations. The second option is to sell the existing offices and build a new office at Newtown. One of the two alternatives must be chosen. If the new office at Newtown is built, one staff position can be saved. This saving should amount to $40,000 per year. However, the Commission will have to pay additional travelling costs and expenses of $20,000 per year if the staff are relocated at Newtown. The following financial information is available to assist the decision where all amounts are to occur at the end of the relevant period:

                                              Rundown          Brokendown           Newtown

Renovations cost                       240,000             370,000

Building cost                                                                                 750,000

Site preparation cost                                                                       40,000

Sale price of properties

If sold now                                 60,000               50,000

Estimated residual value

of properties in 10 years

time

                                                250,000              250,000                650,000

Annual repairs and

maintenance costs

                                                  5,000                  4,000                  6,000

Required to do:

Q1. Calculate the net present value of the cash flows associated with each alternative. Assume a discount rate of 16%. Briefly discuss which alternative, if any, would be recommended to the Commission.

Q2. Briefly discuss how the discount rate of 16% would have been selected by the Commission given your studies in this unit. What bases of comparison should be made in order to justify this discount rate ?

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Finance Basics: Evaluate the net present value of the cash flows
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