A firm that purchases electricity from the local utility for

A firm that purchases electricity from the local utility for $400,000 per year is considering installing a steam generator at a cost of $310,000. The cost of operating this generator would be $260,000 per year, and the generator will last for five years. If the firm buys the generator, it does not need to purchase any electricity from the local utility. The cost of capital is 9%. For the local utility option, consider five years of electricity purchases. For the generator option, assume immediate installation, with purchase and operating costs in the current year and operating costs continuing for the next four years. Assume payments under both options at the start of each year (i.e., immediate, one year from now,..., four years from now). What is the net present value of the more attractive choice?

Solution

Option 1: Buying electricity from a local utility

Net Present value (with immediate start) = 400,000 + 400,000/1.09 + 400,000/1.09^2 +400,000/1.09^3 + 400,000/1.09^4 = $1,695,887.95

Option 2: Installing a steam generator

Initial immediate cost =310,000 + 260,000 = 570,000

Net present value (with immediate start) = 570,000 + 260,000/1.09 +260,000/1.09^2 + 260,000/1.09^3 + 260,000 /1.09^4 = $1,412,327.17

As, we can see OPTION 2 which is installing the steam generator is lower than the first. Hence installing a steam generator is a more attractive choice.