Mutually exclusive projects with different risk levels

Assume that the cost of the third-party storage option will increase 2.5% a year forever. What would the equivalent annuity for this option be?

a. $2.05 million b. $2.50 million c. $ 2 million d. None of the above Explain your answer.

Project Comparison Generalized

To compare projects with different lives, we can make specific assumptions about the types of projects that will be available when the shorter term projects end. To illustrate, we can assume that the firm will have no positive net present value projects when its current projects end; this will lead to a decision rule whereby the net present values of projects can be compared, even if they have different lives. Alternatively, we can make specific assumptions about the availability and the attractiveness of projects in the future, leading to cash flow estimates and present value computations. Again, going back to the 5-year and 10-year projects described in figure 6.4, assume that future projects will not be as attractive as current projects. More specifically, assume that the annual cash flows on the second 5-year project that will be taken when the first 5-year project ends will be $320 instead of $400. The net present values of these two investment streams can be computed as shown in Figure 6.7.

Figure 6.7: Cash Flows on Projects with Unequal Lives: Replicated with poorer project

Five-year Project: Replicated

$400 $400 $400 $400 $400 $320 $320 $320 $320 $320 0 1 2 3 4 5 6 7 8 9 10

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