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

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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