Question

A material supply contractor has two options (i.e. from two different manufacturing companies, Company-1 and Company-2) to purchase a tractor for supply of construction materials. The details of cash flow of the two options are given below; Company-1 Tractor: Initial purchase cost = Rs.2000000, Annual operating cost including labor and maintenance = Rs.50000, Cost of new set of tires to be replaced at the end of year ‘3', year ‘6' and year ‘9' = Rs.110000 each, Expected salvage value = Rs.520000, Useful life = 10 years. Company-2 Tractor: Initial purchase cost = Rs.2200000, Annual operating cost including labor and maintenance = Rs.27000, Cost of new set of tires to be replaced at the end of year ‘4' and year ‘8' = Rs.120000 each, Expected salvage value = Rs.700000, Useful life = 10 years. Determine which company tractor should be selected on the basis of equivalent uniform annual worth at the interest rate of 2 % per year . Clearly demonstrate the Data, Solution and Cash Flow Diagram.

Answer 1

Company 01 :

Useful Life n = 10 Years

interest rate =  2 % Annual = 0.02

Initial purchase cost = Rs.2000,000

Annual operating cost including labor and maintenance(A) = Rs.50,000

PV of Annual Operating Cost =

= 449,129.25

Cost of a new set of tires to be replaced at the end of year ‘3', year ‘6' and year ‘9' (R) = Rs.110,000

PV of a new set of tires to be replaced

= 103,655.45 + 97676.85 + 92,043.07

= 293,375.39

Expected salvage value = Rs.520,000

Present Value of Salvage Value

= 426,581.11

Ans : Net Present Cost

= Initial purchase cost + PV of Annual Operating Cost + PV of a new set of tires to be replaced -

Present Value of Salvage Value

= 2000,000 + 449,129.25 + 293,375.39   - 426,581.11

= 2315,923.52

Equivalent Annual Cost =

= 257,823.72

Company 02 :

Initial purchase cost = Rs.2200,000

Annual operating cost including labor and maintenance(A) = Rs.27,000

PV of Annual Operating Cost =

= 242,529.80

Cost of a new set of tires to be replaced at the end of year '4', year ‘8'   (R) = Rs.120,000

PV of a new set of tires to be replaced

= 213,280.30

Expected salvage value = Rs.700,000

Present Value of Salvage Value

= 574,243.80

Net Present Cost

= Initial purchase cost + PV of Annual Operating Cost + PV of a new set of tires to be replaced -

Present Value of Salvage Value

= 2200,000 + 242,529.80 + 213,280.30 - 574,243.80

= 2081,566.28

Equivalent Annual Cost =

= 231,733.55

Ans : Since Net Present Cost of Company B is lower Company B should be considered.