Question

Your company has two alternatives to consider for purchasing new heat treating ovens for hardening and annealing production metal assemblies. Details of each alternative are given below. Draw the cash flow diagram for each and assume your company’s MARR is 8%. Using a present value comparison which alternative do you recommend?

Alternative A: The TomKin Oven Company will sell your company 5 heat treating ovens with manual feeds and extraction mechanisms. The ovens will initially cost $18,000 each and have an estimated life of 7 years. They will all require insulation overhauls in year 4 costing $2,500 each. At the end of their life each oven is estimated to be worth $2,000. The ovens will result in tougher metal assemblies which is estimated to save the company $57,000 per year total in year 1 increasing by $3,500 per year total every year after year 1.

Alternative B: The Quickspeed Heat Treat Equipment Company will also sell your company 5 heat treating ovens but with automatic feeds and extraction mechanisms. The ovens will initially cost $25,000 each and have an estimated life of 7 years. They will not require any insulation overhauls but are each expected to have maintenance issues costing $700 each in year 1 and then increasing by $400 each for every year after year 1. At the end of their life, each oven is estimated to be worth $3,000. The ovens will result in tougher metal assemblies which is estimated to save the company $70,000 per year total in year 1 increasing by $4,100 per year total every year after year 1.

Answer 1

Alternative A

No. of Ovens= 5

Initial Cost =$18000

Total Initial Cost = 18000*5=$90000

Life 7 years

Overhaul cost in year 4 = $2500*5 = $12500

Salvage value = $2000*5 =$10000

Saving in Year 1 = $57000

Saving in Year 2 = 57000+3500 = 60500

Saving in Year 3 = 60500+3500 = 64000

Saving in Year 4 = 64000+3500 = 67500

Saving in Year 5 = 67500+3500 = 71000

Saving in Year 6 = 71000+3500 = 74500

Saving in Year 7 = 74500+3500 = 78000

Cashflow can be calculated as follows:

	YR0	YR1	YR2	YR3	YR4	YR5	YR6	YR7
Initial Cost	-90000
Overhaul Cost					-12500
Salvage Value								10000
Savings		57000	60500	64000	67500	71000	74500	78000
Total Cashflow	-90000	57000	60500	64000	-12500+67500	71000	74500	10000+78000
Total Cashflow	-90000	57000	60500	64000	55000	71000	74500	88000

Total Present Value can be calculated as follows:

		YR1	YR2	YR3	YR4	YR5	YR6	YR7
Total Cashflow	-90000	57000	60500	64000	55000	71000	74500	88000
Present Value	-90000	=57000/(1+8%)^1	=60500/(1+8%)^2	=64000/(1+8%)^3	=55000/(1+8%)^4	=71000/(1+8%)^5	=74500/(1+8%)^6	=88000/(1+8%)^7
Present Value	-90000	=57000/1.08	=60500/1.08^2	=64000/1.08^3	=55000/1.08^4	=71000/1.08^5	=74500/1.08^6	=88000/1.08^7
Present Value	-90000	=57000/1.08	=60500/1.1664	=64000/1.260	=55000/1.3605	=71000/1.4693	=74500/1.5869	=88000/1.7138
Present Value	-90000	52777.78	51869.00	50805.26	40426.64	48321.41	46947.64	51347.15
Total Present Value	=-90000+52777.78+51869+50805.26+40426.64+48321.41+46947.64+51347.15
Total Present Value	252494.9

Alternative B

No. of Ovens= 5

Initial Cost =$25000

Total Initial Cost = 25000*5=$125000

Life 7 years

Maintenance cost in each year = $700*5 = $3500 with increase of 400*5=$2000 every year

Maintenance cost in Year 2 = 3500+2000= 5500

Maintenance cost in Year 3 = 5500+2000 = 7500

Maintenance cost in Year 4 = 7500+2000 = 9500

Maintenance cost in Year 5 = 9500+2000 = 11500

Maintenance cost in Year 6 = 11500+2000 = 13500

Maintenance cost in Year 7 = 13500+2000 = 15500

Salvage value = $3000*5 =$15000

Saving in Year 1 = $70000

Saving in Year 2 = 70000+4100 = 74100

Saving in Year 3 = 74100+4100 = 78200

Saving in Year 4 = 78200+4100 = 82300

Saving in Year 5 = 82300+4100 = 86400

Saving in Year 6 = 86400+4100 = 90500

Saving in Year 7 = 90500+4100 = 94600

Cashflow can be calculated as follows:

	YR0	YR1	YR2	YR3	YR4	YR5	YR6	YR7
Initial Cost	-125000
Maintenance Cost		-3500	-5500	-7500	-9500	-11500	-13500	-15500
Salvage Value								15000
Savings		70000	74100	78200	82300	86400	90500	94600
Total Cashflow	-125000	66500	-5500+74100	-7500+78200	-9500+82300	-11500+86400	-13500+90500	-15500+15000+94600
Total Cashflow	-125000	66500	68600	70700	72800	74900	77000	94100

Total Present Value can be calculated as follows:

		YR1	YR2	YR3	YR4	YR5	YR6	YR7
Total Cashflow	-125000	66500	68600	70700	72800	74900	77000	94100
Present Value	-125000	=66500/(1+8%)^1	=68600/(1+8%)^2	=70700/(1+8%)^3	=72800/(1+8%)^4	=74900/(1+8%)^5	=77000/(1+8%)^6	=94100/(1+8%)^7
Present Value	-125000	=66500/1.08	=68600/1.08^2	=70700/1.08^3	=72800/1.08^4	=74900/1.08^5	=77000/1.08^6	=94100/1.08^7
Present Value	-125000	=66500/1.08	=68600/1.1664	=70700/1.260	=72800/1.3605	=74900/1.4693	=77000/1.5869	=94100/1.7138
Present Value	-125000	61574.07	58813.44	56111.11	53509.74	50976.65	48522.28	54907.22
Total Present Value	=-125000+61574.07+58813.44+56111.11+53509.74+50976.65+48522.28+54907.22
Total Present Value	259414.51

Since Present value of Alternate B is more it shall be chosen