Question

Consider the determination of whether a worthwhile enterprise should be developed now, or at a later date. Consider a hydro-electric scheme, which if fully developed now will cost $70,000,000, and will have annual operating and maintenance costs averaging $3,500,000. However, if a first stage only is built now for $40,000,000, and the balance in 20 years time, the cost of the latter would then be $39,000,000; and the annual operation and maintenance will be $2,400,000 for the first 20 years and $4,000,000 thereafter. If the interest rate is 6% and the total life 40 years, which is the better alternative

Answer 1

Answer:

The second alternative is the better alternative. That is, it is better to build first stage only is now for $40,000,000, and the balance in 20 years time.

Explanation:

Note: See the attached excel file for the calculation of the present values of the total cash outflows of the two alternatives.

From the attached excel file, we have:

r = interest rate = 6%

Present values of the total cash outflows of the first alternative = -$122,662,039

Present values of the total cash outflows of the second alternative = -$94,492,585

Based on the above, since the present values of the total cash outflows of the second alternative of $94,492,585 is less than the present values of the total cash outflows of the first alternative of $122,662,039, the second alternative is therefore the better alternative. That is, it is better to build first stage only is now for $40,000,000, and the balance in 20 years time.

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