Question

Section 2. Question 1

Al Hassan Engineering has won a tender to build an oil field in the Sea of Oman. In order to transport the workers to the site, Al Hassan Engineering has identified the following two options with related cost: Option1: To buy a ship for OMR 15,000,000. Annual fixed costs will be OMR 300,000 the variable cost per journey is OMR 2,000. At the end of the 3-year project, the ship can be disposed of for OMR 10,000,000. Option2: To buy a helicopter for OMR 7,000,000. The average operating costs will be OMR 500 per trip. Maintenance costs are expected to be OMR 100,000 annually. At the end of the 3-year project, the helicopter can be sold for OMR 4,000,000. The expected cash inflow from either option is OMR 8,000,000 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: Year1 1,000 journeys Year2 1,000 journeys Year3 1,000 journeys Year4 1,000 journeys Al Hassan’s weighted average cost of capital is 7%

Instructions:

a. Compare the Net Present Value (NPV) for both options.

b. Use Microsoft excel to evaluate the Internal Rate of Return (IRR) for the two options.

c. Appraise which option, if either, the company should undertake.

Answer 1

Year	Ship Cost(a)	Annual Fixed Costs(b)	No.of Journeys (c )	Variable costs per journey(d)	Variable costs per annum(e=c*d)	Total Costs (f=a+b+e)	Expected Cash Inflow(g)	Expected Sale Value(h)	Total Cash Inflows(i=g+h)	Net Cash Flows(j=i+f)	PV Factor @7%(k)	PV of cash flows(l=j*k)
-	(15,000,000.00)	-	-	-	-	(15,000,000.00)	-	-	-	(15,000,000.00)	1.00	(15,000,000.00)
1.00	-	(300,000.00)	1,000.00	(2,000.00)	(2,000,000.00)	(2,300,000.00)	8,000,000.00	-	8,000,000.00	5,700,000.00	0.93	5,327,102.80
2.00	-	(300,000.00)	1,000.00	(2,000.00)	(2,000,000.00)	(2,300,000.00)	8,000,000.00	-	8,000,000.00	5,700,000.00	0.87	4,978,600.75
3.00	-	(300,000.00)	1,000.00	(2,000.00)	(2,000,000.00)	(2,300,000.00)	8,000,000.00	10,000,000.00	18,000,000.00	15,700,000.00	0.82	12,815,876.67
4.00	-	(300,000.00)	1,000.00	(2,000.00)	(2,000,000.00)	(2,300,000.00)	8,000,000.00	-	8,000,000.00	5,700,000.00	0.76	4,348,502.71
Total	(15,000,000.00)	(1,200,000.00)		(8,000.00)	(8,000,000.00)	(24,200,000.00)	32,000,000.00	10,000,000.00	42,000,000.00	17,800,000.00	NPV	12,470,082.93

Year	Ship Cost(a)	Annual Fixed Costs(b)	No.of Journeys (c )	Variable costs per journey(d)	Variable costs per annum(e=c*d)	Total Costs (f=a+b+e)	Expected Cash Inflow(g)	Expected Sale Value(h)	Total Cash Inflows(i=g+h)	Net Cash Flows(j=i+f)	PV Factor @7%(k)	PV of cash flows(l=j*k)
-	(7,000,000.00)	-	-	-	-	(7,000,000.00)		-	-	(7,000,000.00)	1.00	(7,000,000.00)
1.00	-	(100,000.00)	1,000.00	(500.00)	(500,000.00)	(600,000.00)	8,000,000.00	-	8,000,000.00	7,400,000.00	0.93	6,915,887.85
2.00	-	(100,000.00)	1,000.00	(500.00)	(500,000.00)	(600,000.00)	8,000,000.00	-	8,000,000.00	7,400,000.00	0.87	6,463,446.59
3.00	-	(100,000.00)	1,000.00	(500.00)	(500,000.00)	(600,000.00)	8,000,000.00	4,000,000.00	12,000,000.00	11,400,000.00	0.82	9,305,795.80
4.00	-	(100,000.00)	1,000.00	(500.00)	(500,000.00)	(600,000.00)	8,000,000.00	-	8,000,000.00	7,400,000.00	0.76	5,645,424.57
Total	(7,000,000.00)	(400,000.00)		(2,000.00)	(2,000,000.00)	(9,400,000.00)	32,000,000.00	4,000,000.00	36,000,000.00	26,600,000.00	NPV	21,330,554.81

Comparision of NPV
NPV of Ship	12,470,082.93	Since NPV of helocopter is high, 2nd option is beneficial
NPV of Helicopter	21,330,554.81

Calculation of IRR	Option A		Calculation of IRR	Option B
Year	Cash Flows(j)		Year	Cash Flows(j)
0	(15,000,000.00)		0	(7,000,000.00)
1	5,700,000.00		1	7,400,000.00
2	5,700,000.00		2	7,400,000.00
3	15,700,000.00		3	11,400,000.00
4	5,700,000.00		4	7,400,000.00
IRR	37%		IRR	107%
	Calculated using excel formula =IRR(Values). Instead we can use trail and error method			Calculated using excel formula =IRR(Values). Instead we can use trail and error method

Since NPV and IRR afre more gor option B, we will select B.

Assumptions:

1. Assuming 1,000 journey sper year includes to and fro.

2. Annual fixed costs will not change according to number of trips

3. Cash Inflows were taken for each year