Question

The NCO Corporation has won a tender to drill an oil field in the Oman Sea. In order to transport the workers to the site, NCO has the following two options with related cost:

Option1:To buy a ship for O.R 20,000,000. Annual fixed operating costs will be O.R 500,000 the variable cost per journey is O.R 1,000. At the end of the four-year project, the ship can be disposed of for O.R 12,000,000.

Option2:To buy a helicopter for O.R 12,000,000. The average operating costs will be O.R 500 per trip. Maintenance costs are expected to be O.R 200,000 annually. At the end of the four-year project, the helicopter can be sold for O.R 4,000,000.

The expected cash inflow from either option is O.R 9,000,000 each year for the four year period. The expected annual demand for transporting employees offshore and back again over the next four years is forecasted as follows:

Year	1	2	3	4
transporting employees/ Ship	1,000 Journeys	1,000 Journeys	1,000 Journeys	1,000 Journeys
transporting employees/ helicopter	4,000 Journeys	4,000 Journeys	4,000 Journeys	4,000 Journeys

NCO’s cost of capital is 7%

Instructions:

Find the Equivalent Annual Cost (EAC) for each option.

Calculate the NPV and the IRR for both projects.

Critically appraise which option, if either, the company should undertake.  

Answer 1

					Op.1	Op.2
					Ship	Helicopter
	Initial investment				20000000	12000000
	Life	(Years)			4	4
	Salvage value				12000000	4000000
	Cash inflow				9000000	9000000
	No. of journeys each year				1000	4000
	Operating cost -
		Fixed cost			500000	200000
		Variable Cost	(per journey)		1000	500
	Cost of capital				7%	7%
	EAC -
		Cash inflow			9000000	9000000
		Operating cost :
		Variable Cost	(Cost per journey x No. of journey each year)		1000000	2000000
		Fixed cost			500000	200000
		Annual Cashflow	(EAC)		7500000	6800000
		PVAF(7%,4 years)			3.3872	3.3872
		PV of cash flows			25404084	23033036.5
	Add:	Salvage value	(Salvage value x PVIF(7%,4))		9154742.5	3051580.85
	Less:	Initial investment			20000000	12000000
		NPV =			14558827	14084617.4
		PVAF(7%,4 years)			3.3872	3.3872
		EAC = NPV / PVAF			4298175.1	4158175.07
	IRR =	Rate at which NPV = 0 i.e. Outflow = Inflow
	Option 1 =	Cost of ship =	Annual cashflow + Salvage value
		20000000 =	7500000 x PVAF(r, 4) + 12000000 x PVIF(r,4)
		At r =		NPV
		58%		10839.99402
		r		0
		59%		-122328.801
		Using linear interpolation -
		r - 58/ 59-58 =	0- 10839.99/(-122328.80 - 10839.99)
		r-58 =	0.0814
		r =	58 + 0.0814
		r =	58.0814
	Option 2 =	Cost of helicopter =	Annual cashflow + Salvage value
		12000000 =	6800000 x PVAF(r, 4) + 4000000 x PVIF(r,4)
		At r =		NPV
		65%		101687.8958
		r		0
		66%		-2241.30452
		Using linear interpolation -
		r - 65/ 66-65 =	0-101687.89/(-2241.30 - 101687.89)
		r - 65 =	0.978434
		r =	65 + 0.9784
		r =	65.9784
					Op.1	op.2
		EAC			4298175.1	4158175.07
		NPV			14558827	14084617.4
		IRR			58.0814	65.9784
	Please provide feedback…. Thanks in advance…. :-)