Question

Clear Water Company has a down-hole well auger that was purchased 3 years ago for $30,000. O&M costs are $13,000 per year. Alternative A is to keep the existing auger. It has a current market value of $12,000 and it will have a $0 salvage value after 7 more years. Alternative B is to buy a new auger that will cost $54,000 and will have a $14,000 salvage value after 7 years. O&M costs are $6,000 for the new auger. Clear Water can trade in the existing auger on the new one for $15,000. Alternative C is to trade in the existing auger on a “treated auger” that requires vastly less O&M cost at only $3,000 per year. The “treated auger” costs $68,000, and the trade-in allowance for the existing auger is $17,000. The “treated auger” will have a $18,000 salvage value after 7 years. Alternative D is to sell the existing auger on the open market and to contract with a current competitor to use their equipment and services to perform the drilling that would normally be done with the existing auger. The competitor requires a beginning-of-year retainer payment of $10,000. End-of-year O&M cost would be $6,000. MARR is 15% and the planning horizon is 7 years.

Please show cash flow diagram and do not use excel functions.

a. Clearly show the cash flow profile in the table below for each alternative using a cash flow approach (insider’s viewpoint). No EUAC calculations in this letter.

EOY	Alternative A	Alternative B	Alternative C	Alternative D

b. Using an EUAC and a cash flow approach, decide which is the more favorable alternative.

c. Clearly show the cash flow profile in the table below for each alternative using an opportunity cost approach (outsider’s viewpoint). No EUAC calculations in this letter.

EOY	Alternative A	Alternative B	Alternative C	Alternative D

d. Using an EUAC and an opportunity cost approach, decide which is the more favorable alternative.

Answer 1

EOY	Alternative A	Alternative B	Alternative C	Alternative D
0	0	(39,000)	(51,000)	12,000
1	(13,000)	(6,000)	(3,000)	(6,000)
2	(13,000)	(6,000)	(3,000)	(6,000)
3	(13,000)	(6,000)	(3,000)	(6,000)
4	(13,000)	(6,000)	(3,000)	(6,000)
5	(13,000)	(6,000)	(3,000)	(6,000)
6	(13,000)	(6,000)	(3,000)	(6,000)
7	(13,000)	8,000	15,000	(6,000)
Net Initial cost	-	54,000-15,000	68,000-17,000	10,000-12,000
Seventh year is net of salvage value

b. EUAC formula, for initial investment = Initial Cost* r* (1+r)ⁿ

                                                                                     (1+r)ⁿ - 1

                                For salvage value = Salvage value* r

                                                                                (1+r)ⁿ - 1            

                                For O &M, - Same as the actual value.

Total EUAC = EUAC for initial investment - Salvage Value + O&M.

	Alternative A	Alternative B	Alternative C	Alternative D
Initial	-	(9,374)	(12,258)	481
salvage	-	1,265	1,626	-
O&M	(13,000)	(6,000)	(3,000)	(6,000)
Total	(13,000)	(14,109)	(13,632)	(5,519)

It can be seen from the table that Alternative D is the best option.