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# FM11 45 - that is the machinery will be totally worn out...

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k. 4. Now assume that the cost to replicate project S 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? Answer: If the cost of project S is expected to increase, the replication project is not identical to the original, and the EAA approach cannot be used. In this situation, we would put the cash flows on a time line as follows: 0 1 2 3 4 | | | | | r = 10% -100,000 60,000 60,000 60,000 60,000 -105,000 - 45,000 Common Life NPV S = \$3,415. With this change, the common life NPV of project s is less than that for project L, and hence project L should be chosen. l. You are also considering another project which has a physical life of 3 years;
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Unformatted text preview: 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 2,100 3,100 2 2,000 2,000 3 1,750 0 Using the 10 percent 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? Mini Case: 11 - 45...
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