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The State Power and Electricity Commission

The State Power and Electricity Commission has branch offices in two country towns,
Rundown and Brokendown. As well as providing customer account payment services, the
offices also serve as bases for technicians who do repair and maintenance work on power lines and equipment in the area.

The Commission is considering closing down both these branch offices and building a new
office at another town, Newtown. Newtown is halfway between Rundown and Brokendown
and would be the base for customer and equipment maintenance services for all three towns.
Part of the reason for considering the move at this time is that both the existing branch offices
are in very poor shape. If the commission decides to retain the existing locations, the offices at Rundown and Brokendown will both need some structural repair and extensive renovations.
The Commission, therefore, has two alternatives. The first option is to retain the existing
locations and carry out the renovations. The second option is to sell the existing offices and
build a new office at Newtown. One of the two alternatives must be chosen.

If the new office at Newtown is built, one staff position can be saved. This saving should
amount to $40,000 per year. However, the Commission will have to pay additional travelling
costs and expenses of $20,000 per year if the staff are relocated at Newtown.

The following financial information is available to assist the decision where all amounts are to
occur at the end of the relevant period:
Rundown Brokendown Newtown
Renovations cost 240,000 370,000
Building cost 750,000
Site preparation cost 40,000
Sale price of properties
If sold now 60,000 50,000
Estimated residual value
of properties in 10 years
time
250,000 250,000 650,000
Annual repairs and
maintenance costs
5,000 4,000 6,000
Required :
a) Calculate the net present value of the cash flows associated with each alternative.
Assume a discount rate of 16%. Briefly discuss which alternative, if any, would be
recommended to the Commission.
b) Briefly discuss how the discount rate of 16% would have been selected by the
Commission given your studies in this unit. What bases of comparison should be made
in order to justify this discount rate ?

See attached file for full problem description.

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Solution Preview

a) Calculate the net present value of the cash flows associated with each alternative.
Assume a discount rate of 16%. Briefly discuss which alternative, if any, would be
recommended to the Commission.

First alternative

First, we need to find the NPV for both locations as follows: -

Find NPV by finding the present value of each cash flow, including both inflows and outflows, discounted at the project's cost of capital.
We will consider the payment and additional expenses as cash outflow while the cash receipt and saving will be regarded as cash inflow.

NPV = sum of CFt where CF is the cash flow
(1 + k)t k is the cost of capital
t is the period.

For Rundown, the cash flow is as follows: -
0 ...

Solution Summary

This solution is comprised of a detailed explanation to answer the request of the assignment of more than 800 words of text.

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