Problem 1

Performance, Inc. is faced with choosing between two mutually exclusive projects with differing lives. It requires a return of 12% on these projects. Project A requires an initial outlay at time 0 of $5,000,000 and is expected to require annual maintenance cash outflows of $3,100,000 per year over its 2-year life. Project B requires an initial outlay at time 0 of $6,000,000 and is expected to require annual maintenance cash outflows of $2,600,000 per year over its 3-year life. Both projects are acceptable investments and provide equal quality service. The firm assumes that the replacement and maintenance costs for both projects will remain unchanged over time.

1. Find the NPV of each project over its life.
2. Which project would you recommend based on your finding in part a? What is wrong with choosing the best project based on its NPV?
3. Use the equivalent annual cost (EAC) method to compare the two projects.
4. Which project would you recommend based on your finding in part c? Compare and contrast this recommendation with the one you gave in part b.