Question

The company is considering the installation of a high-end server for handling the system with the first initial cost of $25,000,000. This system will save $7,500,000 per year in spare part cost, but it will incur $2,750,000 in annual operating and maintenance expenditures. The salvage value at the end of the system’s 4 years' life is $1.500,000.

At the end of the project, the company will invest the new server for the next 4 upcoming years with initial the initial cost of $50,000,000. This new system will save $8,500,000 per year in spare part cost, but it will incur $3,850,000 in annual operating and maintenance expenditures. The salvage value at the end of the system’s 4-year is negligible.

There is another option to cover the requirement by combining 2 different situations. In the first 4 years, the company will rent a high-end server for the handling system the rent costs $5,000,000/ year. There is no budget that needs to be allocated for spare part cost, and it will incur $1,500,000 in annual operating and maintenance expenditures. In the second period, the company will invest the new server for the next 4 upcoming years with initial the initial cost of $50,000,000. This new system will save $8,500,000 per year in spare part cost, but it will incur $3,850,000 in annual operating and maintenance expenditures. The salvage value at the end of the system is negligible.

If the company’s hurdle rate (MARR) is 8% per year, which scenario that should be recommended for implementation?

Draw the cash flow and calculate using excel

Answer 1

For Scenario 1:

End of Year	Initial Cost	O&M Cost	Savings	Salvage Value	Net Cashflow	PV of Cashflow
A	B	C	D	E	F=B+C+D+E	G=F/1.08^A
-	-25,000,000.00				-25,000,000.00	-25,000,000.00
1.00		-2,750,000.00	7,500,000.00		4,750,000.00	4,398,148.15
2.00		-2,750,000.00	7,500,000.00		4,750,000.00	4,072,359.40
3.00		-2,750,000.00	7,500,000.00		4,750,000.00	3,770,703.14
4.00	-50,000,000.00	-2,750,000.00	7,500,000.00	1,500,000.00	-43,750,000.00	-32,157,556.06
5.00		-3,850,000.00	8,500,000.00		4,650,000.00	3,164,711.87
6.00		-3,850,000.00	8,500,000.00		4,650,000.00	2,930,288.77
7.00		-3,850,000.00	8,500,000.00		4,650,000.00	2,713,230.34
8.00		-3,850,000.00	8,500,000.00		4,650,000.00	2,512,250.31
					Total	-33,595,864.09

For Scenario 2:

End of Year	Initial Cost	Rent Cost	O&M Cost	Savings	Net Cashflow	PV of Cashflow
A	B	C	D	E	F=B+C+D+E	G=F/1.08^A
-					0.00	0.00
1.00		-5,000,000.00	-1,500,000.00		-6,500,000.00	-6,018,518.52
2.00		-5,000,000.00	-1,500,000.00		-6,500,000.00	-5,572,702.33
3.00		-5,000,000.00	-1,500,000.00		-6,500,000.00	-5,159,909.57
4.00	-50,000,000.00	-5,000,000.00	-1,500,000.00		-56,500,000.00	-41,529,186.68
5.00			-3,850,000.00	8,500,000.00	4,650,000.00	3,164,711.87
6.00			-3,850,000.00	8,500,000.00	4,650,000.00	2,930,288.77
7.00			-3,850,000.00	8,500,000.00	4,650,000.00	2,713,230.34
8.00			-3,850,000.00	8,500,000.00	4,650,000.00	2,512,250.31
					Total	-46,959,835.82

So we see that Scenario 1 costs less than Scenario 2 with a MARR of 8%. So it is recommended to go ahead with scenario 1 in this case.

If you found this helpful, please rate it so that I can have higher earnings at no extra cost to you. This will motivate me to write more.