Question

Dixie Dynamite Company is evaluating two methods of blowing up old buildings for commercial purposes over the next five years. Method one (implosion) is relatively low in risk for this business and will carry a 12 percent discount rate. Method two (explosion) is less expensive to perform but more dangerous and will call for a higher discount rate of 16 percent. Either method will require an initial capital outlay of \(75,000. The inflows from projected business over the next five years are shown next. Which method should be selected using net present value analysis?

Year Method 1 Method 2

1 .................................... \)18,000 $20,000

2 .................................... 24,000 25,000

3 .................................... 34,000 35,000

4 .................................... 26,000 28,000

5 .................................... 14,000 15,00

Short answer

Method 1 shall be selected as the Net present vale of method 1 is higher than the Net present value of Method 2 i.e., 8,884.

Step-by-step solution

Step 1:Computation of Present value of Method 1-

Year	Inflows	Present value factor @12%	Present value
1	$18,000	0.893	$16,074
2	$24,000	0.797	$19,128
3	$34,000	0.712	$24,208
4	$26,000	0.636	$16,536
5	$14,000	0.597	$7,938
			$83,884

Computation of Present value of Method 2-

Year	Inflows	Present value factor @16%	Present value
1	$20,000	0.862	$17,240
2	$25,000	0.743	$18,575
3	$35,000	0.641	$22,435
4	$28,000	0.552	$15,456
5	$15,000	0.476	$7,140
			$80,846

Computation of Net present value of Method 1-

$\begin{array}{c}\mathbf{Net}\mathbf{}\mathbf{present}\mathbf{}\mathbf{value}\mathbf{=}\mathbf{Present}\mathbf{}\mathbf{value}\mathbf{}\mathbf{of}\mathbf{}\mathbf{inflow}-\mathbf{Investment}\\ \mathbf{=}\mathbf{\$}\mathbf{83}\mathbf{,}\mathbf{884}-\mathbf{\$}\mathbf{75}\mathbf{,}\mathbf{000}\\ =\$8,884\end{array}$

Computation of Net present value of Method 2-

$\begin{array}{c}\mathbf{Net}\mathbf{}\mathbf{present}\mathbf{}\mathbf{value}\mathbf{=}\mathbf{Present}\mathbf{}\mathbf{value}\mathbf{}\mathbf{of}\mathbf{}\mathbf{inflow}-\mathbf{Investment}\\ \mathbf{=}\mathbf{\$}\mathbf{80}\mathbf{,}\mathbf{846}-\mathbf{\$}\mathbf{75}\mathbf{,}\mathbf{000}\\ =\$5,846\end{array}$