Question

You are considering three methods for producing steam in your company's manufacturing plant, all of which are repeatable. Revenues will be the same regardless of the method chosen. An oil boiler costs $300,000 and it has a useful life of six years. The costs of operating the oil boiler require after-tax cash flows of $250,000 per year. A gas boiler costs $200,000 and it has a useful life of five years. The costs of operating the gas boiler require after-tax cash flows of $350,000 per year. An electric boiler costs $150,000 and it has a useful life of eight years. The costs of operating the electric boiler require after-tax cash flows of $400,000 per year. If your company's weighted average cost of capital is 14% per year, by which method should you generate steam? What is annualized cost of producing steam by the preferred method?

Answer 1

Equivalent annual cost, EAC = Initial cost /PVIFA (i, n) + annual operating cost

EAC of oil boiler = $ 300,000 / PVIFA (14 %, 6) + $ 250,000

                            = $ 300,000 / 3.8887 + $ 250,000

                            = $ 77,146.60426 + $ 250,000

                            = $ 327,146.6043 or $ 327,146.60

EAC of gas boiler = $ 200,000 / PVIFA (14 %, 5) + $ 350,000

                             = $ 200,000 / 3.4331 + $ 350,000

                             = $ 58,256.38636 + $ 350,000

                             = $ 408,256.3864 or $ 408,256.39

EAC of electric boiler = $ 150,000 / PVIFA (14 %, 8) + $ 400,000

                             = $ 200,000 / 4.6389 + $ 400,000

                             = $ 32,335.25189 + $ 400,000

                             = $ 432,335.2519 or $ 432,335.25

Oil boiler is preferred as its EAC is less than other two boilers.

Annualized cost of producing steam by oil boiler is $ 327,146.60