Question

.  Sanderson Sand Co. is looking at 2 projects – Project N and Project O.  The cashflows of the 2 projects are as follows:

Project N                                                        Project O

Year 0            (3000)                                    Year 0            (5000)

Year 1            1,700                                      Year 1            3,200

Year 2            1,600                                      Year 2            1,800

Year 3            1,000                                      Year 3              900

Year 4            1,300                                      Year 4              700

                                                                     Year 5              500

Year 6              400

The firm’s cost of capital is 10%.

Calculate the replacement-chain NPV for each project.  Which project would be preferred under the replacement chain method?

Answer 1

Project N

Cash outflow = 3,000

Discount rate = 10%

Year 1 = 1,700*0.9090 = 1,545.30

Year 2 = 1,600*0.8264 = 1,322.24

Year 3 = 1,000*0.7513 = 751.30

Year 4 = 1,300*0.6830 = 887.90

Total present value of cash Inflow = $4,506.74

Net present value =

Total present value of cash Inflow - Cash outflow

= 4,506.74 - 3,000

= $1,506.74

Project O

Cash outflow = 5,000

Discount rate = 10%

Year 1 = 3,200*0.9090 = 2,908.80

Year 2 = 1,800*0.8264 = 1,487.52

Year 3 = 900*0.7513 = 676.17

Year 4 = 700*0.6830 = 478.10

Year 5 = 500*0.6209 = 310.45

Total present value of cash Inflow = $5,861.04

Net present value =

Total present value of cash Inflow - Cash outflow

= 5,861.04 - 35000

= $861.04.

As the net present value is higher of project N

Therefore project N should be selected.