Question

Fairland Enterprises, Inc. is considering two mutually exclusive projects, A and B. This project is

mandated by state regulatory law to ensure employee safety in the firm’s production facility. Each of these

projects generates no cash inflows. Instead, annual operating costs will be incurred to operate each project as

per the information provided in the following table:

	Project A	Project B
Initial Investment at t = 0	($20,000)	($30,000)
Project Life	3 years	4 years
Annual Operating Cost	($7,000)	($10,000)

          Inflation is not expected to affect costs. Assume that the firm’s cost of capital is 15 percent. Assume that at the end of the useful life of each project, Fairland Enterprises will invest in a new project with identical characteristics. I.e., Fairland could purchase Project A today and it would then buy a new, identical version of Project A every three years. Fairland Enterprises could purchase Project B today and it would then buy a new, identical version of Project B every four years.

1. Calculate the “equivalent annual cost” of operating Project A. In your calculation, include the annual payment (PMT) value, treating the initial cost of Project A as an annual annuity, plus Project A’s annual operating cost.

2. Calculate the “equivalent annual cost” of operating Project B. In your calculation, include the annual payment (PMT) value, treating the initial cost of Project B as an annual annuity, plus Project B’s annual operating cost.

c) Based upon the “equivalent annual costs” that you have calculated for each project above, which project should be chosen – Project A or Project B? Why?

Answer 1