Question

A transit company is considering two alternative buses to transport people between cities that are in the same region. A gas-powered bus has a cost of $55,000, and will produce end-of-year net cash flows of $22,000 per year for 4 years. A new electric bus will cost $90,000, and will produce cash flows of $28,000 per year for 8 years. The company must provide bus service for 8 years, after which it plans to give up its franchise and to cease operating the route. Inflation is not expected to affect either costs or revenues during the next 8 years. If the cost of capital is 16%, by what amount will the better project increase the company’s value (rounded to the nearest dollar) over the worse project?

a. $6,556

b. $(14,432)

c. $13,112

d. $21,438

Answer 1

Solution: The answer is d. $21,438.

Explanation:

If gas powered bus is purchased: 1 bus purchased in the starting of 1st year & 1 bus will be purchased in the starting of 5th year as the useful life of the bus is 4 years.

Present value of cash inflow (Cash anflow * Present value annuity factor for 8 years @ 16%)	$22,000 * 4.3436	$95,559
Less: Initial cost		$55,000
Less: Present value of the cost that purchased in 5th year	$55,000 * 0.5523	$30,376
Net Present Value		$10,183

If electric bus is purchased:

Present value of cash inflow (Cash anflow * Present value annuity factor for 8 years @ 16%)	$28,000 * 4.3436	$121,621
Less: Initial cost		$90,000
Net Present Value		$31,621

Increase in the value by the better project over the worse project

= $31,621 - $10,183 = $21,438

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