You are considering three methods for producing steam in your company\'s manufac
ID: 2813496 • Letter: Y
Question
You are considering three methods for producing steam in your company's manufacturing plant. Revenues will be the same regardless of the method chosen. An oil boiler costs $300,000 and it has a useful life of six years. The costs of operating the oil boiler require after-tax cash flows of $250,000 per year. A gas boiler costs $200,000 and it has a useful life of five years. The costs of operating the gas boiler require after-tax cash flows of $350,000 per year. An electric boiler costs $150,000 and it has a useful life of eight years. The costs of operating the electric boiler require after-tax cash flows of $400,000 per year. If your company's weighted average cost of capital is 14% per year, by which method should you generate steam? What is annualized cost of producing steam by the preferred method?
Explanation / Answer
Calculation of present value of cash outflows when steam is produced using oil boiler
Cost of oil boiler = $300,000
Life of boiler = 6 years
Cost of operating the oil boiler = $250,000
Cost of capital = 14%
Present value of cash outflows = Present cash outflow + [Annual cash outflow x PVAF(14%, 6)]
= 300,000 + (250,000 x 3.889)
= 300,000 + 972,250
= $12,72,250
Calculation of present value of cash outflows when steam is produced using gas boiler
Cost of oil boiler = $200,000
Life of boiler = 5 years
Cost of operating the gas boiler = $350,000
Cost of capital = 14%
Present value of cash outflows = Present cash outflow + [Annual cash outflow x PVAF(14%, 5)]
= 200,000 + (350,000 x 3.433)
= 200,000 + 1,201,550
= $1,401,550
Calculation of present value of cash outflows when steam is produced using electric boiler
Cost of electric boiler = $150,000
Life of boiler = 8 years
Cost of operating the electric boiler = $400,000
Cost of capital = 14%
Present value of cash outflows = Present cash outflow + [Annual cash outflow x PVAF(14%, 8)]
= 150,000 + (400,000 x 4.639)
= 150,000 + 1,855,600
= $2,005,600
Since the present value of cash outflows is lowest when steam is produced using oil boiler, hence steam should be produced using oil boiler.
Annualised cost of producing steam using oil boiler = Present value of cash outlows/PVF(14%, 6)
= 12,72,250/3.889
= $327,141
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