1) A natural gas distribution company is evaluating the economic desirability of

ID: 1114278 • Letter: 1

Question

1) A natural gas distribution company is evaluating the economic desirability of replacing or repairing existing gas mains, it is estimated that 100,000 Mcf of gas being lost per year and that this gas could be sold to corporate customers at $8.00 per Mcf. The cost of replacing the gas mains is estimated to be $4,000,000 at time zero. Replacement of the mains would effectively eliminate all as loss for the next 10 years. The cost of repairing the gas mains is estimated to be $1,600,000 which would reduce annual gas loss to 25,000 Mcf at year one (allocated to the end of the year), with gas loss increasing by a constant gradient of 6,000 Mcf per year in years following year one. Use net present value analysis for a 10-year evaluation life and 15.0% to determine from an economic viewpoint if the gas mains should be replaced, repaired, or left in the present condition

Explanation / Answer

Answer:

Gas lost due to leakage =100,000Mcsf

If the gas is sold to corporate revenue earned =100,000 * $8.

=$800,000.

Cost of replacing the gas mains =$4,000,000.----------------(1)

These would work for the next10 years.

Hence, $800,000 would be earned for the next 10 years.

formula for present value annuity factor =(1-(1+i)^-n)/i

Where i is the discount rate

and n is the number of periods.

Present value of $800,000 for 10 years @ 15% discount rate =$800,000 *(1-(1+.15)^-10)/.15

=$800,000 * 5.0188

=$4,015,014.901----------(2)

NPv=(2)-(1)

=$15,014.90.

Analysis of repairing gas mains:

Cost of repairing gas mains =$160,000

Gas loss reduced by the end of year 1 =25,000Mcf

Revenue earned by the sale of this gas =25,000 *8=$200,000.

Year

Gas saved

Revenue earned on sale

Present value factor@15%

Present value

25000

$200,000.00

0.869565217

$173,913.04

19000

$152,000.00

0.756143667

$114,933.84

13000

$104,000.00

0.657516232

$68,381.69

7000

$56,000.00

0.571753246

$32,018.18

1000

$8,000.00

0.497176735

$3,977.41

Total

$393,224.16

NPV=Preent value of cash inflow - Present value of cost

=$393,224.16 - $160,000

=$233,224.16.

As the NPV is higher in the second case, ie., repariing gas mains, this should be opted, i.e., repair the gas mains instaed of replacing them.