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Sir I need to ask this question, I am writing here:
“Division A has requested that it be allowed to invest $500,000 in solar panels, which would be fitted to the roof of its production facility. The solar Panels would save Energy cost of $700/day but only on sunny days.The Division estimated the following probabilities:
Number of days Probability
Scenario 1 100 0.3
Scenario 2 125 0.6
Scenario 3 150 0.1Each Scenario is expected to persist indefinitely i.e if there are 100 sunny days in first year then there will be 100 days in every subsequent year. Maintenance costs for the solar panels are expected to be $2000 per month irrespective of sunny days.The solar panels are expected to be used indefinitely.
Before Tax cost of capital is 10%
Required:
(a) The Net present value of each expected number of sunny days
(b) The Overall Expected net present value of the proposal”Sir when I am Calculating an answer I am doing it by Multiply each sunny day with its probability, but in kaplan kit the answer is quite confusing, specially they divide each year cost saving by 10% and then deduct $500,000 each year, and then use expected values and NPV only, Sir Please do Explain
Firstly, part (a) (i) of the question asks for the net present value for EACH expected number of sunny days. So for this part you need the NPV for each of them separately.
Part (a) (ii) asks for the expected NPV. For this part you could do what you have written, but if you have done part (i) it is easier and quicker just to multiply the NPVs by the probabilities and add them up.The reason for dividing each years savings by 10% is the saving will be every year in perpetuity. To get the NPV of a perpetuity we multiply by 1/r which is the same as dividing by r (which is the cost of capital).
The reason for then subtracting 500,000 is because that is the initial investment required.
We invest 500,000 and then get a saving of (for scenario 1) of 46,000 per year in perpetuity.
The PV of 46,000 a year is 460,000 and so the NPV is: 460,000 – the investment of 500,000 = (40,000).
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