Question 1 Suppose you work for a major steel producer in Northwest Indiana and oversee decisions...

Question 1

Suppose you work for a major steel producer in Northwest Indiana and oversee decisions about maintenance and repairs of manufacturing equipment. One day, your team informs you that they have discovered that an important machine is on track to fail in exactly three years. You are then faced with three options:

Option 1: Do nothing.
You can do nothing, and the machine will fail three years from now causing damage to other components when it fails. Replacing the machine and the other damaged components at that time will cost $1,000,000.

Option 2: Perform temporary repairs.
You can complete some temporary repairs, which will cost you $200,000 right now and the machine will still fail in three years, but then when it fails it won’t damage other components and replacing the machine at that time will cost you $750,000.

Option 3: Replace the machine now.
You can replace the machine right now rather than waiting for it to fail in three years, which will cost $850,000 now.

For all three options assume that everything else will be identical after these three years (i.e. you will have a machine that works perfectly fine) and that there are no other costs that have not been mentioned. Considering these three options, answer the following questions:

If interest rates are at 4% per year, what is the present value (cost) of each option? Hint: think of calculating the present value of a cost as calculating the present value of a negative payment. Based on this, which option should you choose and why?

If interest rates are 7% per year, what is the present value (cost) of each option? Based on this, which option should you choose and why?

If interest rates are 10% per year, what is the present value (cost) of each option? Based on this, which option should you choose?

Based on your answers to the parts above, what can you conclude about how market interest rates affect decisions to repair or replace older equipment and how might this affect worker safety?

Qx	Px	Py	Pz	A
524	3.21	4.68	4.56	4604
398	7.25	7.26	7.53	2844
493	5.09	5.3	5.54	3996
564	5.33	1.98	0.65	5713
544	4.49	4.82	4.73	5084
441	3.59	4.2	4.5	3173
362	4.41	3.39	1.94	1728
442	5.28	2.29	2.4	3719
512	5.03	4.25	4.04	4781
423	3.01	0.86	1.53	2791

Qx	Px	Py	A
524	3.21	4.68	4604
398	7.25	7.26	2844
493	5.09	5.3	3996
564	5.33	1.98	5713
544	4.49	4.82	5084
441	3.59	4.2	3173
362	4.41	3.39	1728
442	5.28	2.29	3719
512	5.03	4.25	4781
423	3.01	0.86	2791

Solutions

Expert Solution

Present Value = Future Value/(1 + Interest Rate)n
where n = number of years

4) When the interest rate is 4%, then the best and most cost-effective option for repair is Option 3
When the interest rate is 7%, then the best and most cost-effective option for repair is Option 2
When the interest rate is 10%, then the best and most cost-effective option for repair is Option 1

We can see that as and when the interest rate increase, the present value reduces. In other words, you will have to save less today if you have a higher interest rate because of the compounding effect.
From a worker's safety point of view, option 1 is the most dangerous one as it will do more harm in a later stages if no action is taken today.

jeff jeffy answered 1 year ago

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