Chapter 6

The application of project evaluation

methods

Solutions to questions

1. The items that should be included are (a) and (b). The reasons for exclusion of the other
items are as follows:
(c) sunk cost;
(d) allocated cost. Depends.
(e) sunk cost.

2. The nominal discount rate includes an allowance for expected inflation, whereas the real
discount rate provides no adjustment for expected inflation. Mathematically:

1 i
i*  1
1 p
where i *= real rate of interest per annum
i = nominal rate of interest per annum
p = expected inflation rate per annum
Hence:
i* = i – p – i*p

For low inflation rates and discount rates, the cross-product term i*p will be small and the
real discount rate can be approximated by the difference between the nominal discount
rate and the inflation rate.

3. The items that should be considered are as follows:

(a) the $6000 is a cash flow that reduces the net outlay required to change machines
(b) the installation cost will be incurred in making the new machine ready for service
(c) the $10 000 is a cash outflow that forms part of the investment needed for the
project.

5. Two methods are as follows:

(a) calculate the net present values of the projects, in perpetuity, using the constant chain
of replacement model
(b) calculate the net present values of the projects, for a common life, using the lowest
common multiple method to calculate the common life.

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6. Two projects are said to be mutually exclusive if the selection of one project will
automatically preclude the other project from being selected. This can be generalised to
an n-project case. If a company owns land on which it can build either a factory or a
warehouse, these two projects are said to be mutually exclusive because if a decision is
made to build the factory, it is then impossible for the company to build the warehouse.
The NPV rule for mutually exclusive projects with equal lives is to choose the project
that gives the largest positive NPV. By choosing the project with the largest positive
NPV, the company’s market value is maximised.

8. Students should compare the techniques for replacement and retirement discussed in
Section 6.4. Replacement decisions involve those situations where a company intends to
continue a particular type of operation for an indefinite period. This means that a
company’s need for plant and equipment associated with a particular project will
continue long after the present plant and equipment has been sold or scrapped. A
company is therefore faced with a decision about when the existing plant and equipment
should be replaced. In contrast, retirement decisions involve those situations where a
company uses plant and equipment that will not be replaced.

Solutions to problems

3. Consider the differential cash flows for manufacturing versus buying. Assume zero
residual value at the end of 15 years. Direct production costs = 2 000 000  $2.50 =
$5 000 000 per year. Purchase costs avoided = 2 000 000  ($550/100) = $11 000 000 per
year.

Net present value =

 1 
1  1.1215 
–$3 000 000 – $400 000 + [$11 000 000 – $5 000 000] 
0.12

 
 
–$250 000/1.125 – $250 000/1.1210 + $400 000/1.1215
= $37 315 915

Therefore, it is more profitable to make the DVDs.

(There is no overhauling in the last year.)

($11millions per year is the savings.)

(During workshops, I taught as two Projects: A. Purchase DVDs; B. Produce DVDs)

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 CHAPTER 6

6. The aim is to minimise the NPV of cash outflows.

(a) Assuming a 10 per cent required rate of return:

Machine A
 1 
1  (1.10) 10 
NPV = –$50 000 – $20 000  
 0.10 
 
 
= –$172 891

Machine B
 1 
1  (1.10) 10 
NPV = –$85 000 – $15 000  
 0.10 
 
 
= –$177 169
Decision: Choose A

(b) Assuming a 7 per cent required rate of return:

Machine A
 1 
1  (1.07)10 
NPV = –$50 000 – $20 000  
 0.07 
 
 
= –$190 472

Machine B
 1 
1  (1.07)10 
NPV = –$85 000 – $15 000  
 0.07 
 
 
= –$190 354
Decision: Choose B

 1 
1  (1.10) 12 
7. Savings: $20 000   = $136 274
 0.10 
 
 
less Expenditure:
Initial outlay –$125 000

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Overhaul after 2 years $3000/(1.10)2 –$2479

Overhaul after 4 years $3000/(1.10)4 –$2049
Overhaul after 6 years $3000/(1.10)6 –$1693
Overhaul after 8 years $3000/(1.10)8 –$1400
Overhaul after 10 years $3000/(1.10)10 –$1157
Net present value $2496

Decision: As the net present value is positive, the equipment should be purchased.

(There is no overhauling in the last year.)

13. Van A:

$47 000 $50 000 $50 000 $58 000

NPV = $-100000      $30 795
1.2 (1.2) 2 (1.2) 3 (1.2) 4
Therefore, NPV of Van A has been calculated correctly.

Van A:
1.2  4
EAV = $30 795  0.2  = $11 895
(1.2) 4  1
Van B:
(1.2) 5
EAV = $32 881  0.2  = $10 995
(1.2) 5  1

Van C:
(1.2) 4
EAV = $26 801  0.2  = $10 353
(1.2) 4  1
Since Van A has the highest equivalent annual value, it should be purchased.

(During workshops, I used the NPV∞ for Van A: 59475; Van B: 54975; Van C: 51765)

16. If continue to operate old machine If purchase machine

$ $
(a) Initial cost not relevant (60 000)
(b) Disposal value of old machine not relevant 15 000

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 CHAPTER 6

 1   1 
1  (1.10) 3  1  (1.10) 3 
(c) Operating costs (22 000)   (11 000)  0.10 
 0.10  
   
   

= (54 711) = (27 355)

(54 711) (72 355)

Decision: Continue to operate the old machine which has a lower net present value cost.

19. (a) First way:

Calculate rates of growth in net future value for timber:

Years Growth rate

$20 000  $17 320
2–3 = 15.47%
$17 320

$22 360  $20 000

3–4 = 11.8%
$20 000

$24 495  $22 360

4–5 = 9.55%
$22 360

Since the growth rate falls below 10% (the required rate of return) after Year 4, the
trees should be harvested at the end of Year 4.

 22 360 
(b) NPV = $500  4
 $12 000  = $1 636 090
 (1.1) 
Note that the value of the land can be ignored, because it increased at 10% per
annum which is equal to the required rate of return. Therefore, the land has an NPV
= 0.

(a) Second way:

$17320
NPVharvest in  year 2   12000  2314
(1.1) 2

$20000
NPVharvest in  year 3   12000  3026
(1.1)3

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$22360
NPVharvest in  year 4   12000  3272
(1.1) 4

$24495
NPVharvest in  year 5   12000  3209
(1.1)5

$26450
NPVharvest in  year 6   12000  2930
(1.1)6

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