You are considering two alternative plant layouts, A1 and A2, to improve its cur
ID: 2996602 • Letter: Y
Question
You are considering two alternative plant layouts, A1 and A2, to improve its current layout. The cash flows are shown below. The first costs represent the expenses of rearranging the current layout to the alternative new layout and the annual savings represent the reduction in the production costs of the new layout compared to the current layout. Using the internal rate of return as the decision criterion, what course of action do you recommend? Use MARR = 10%.
Data
Year
A1
A2
First Cost
0
-$110,000
-$115,000
Annual Savings
1 to Infinity
$12,500
$15,000
Data
Year
A1
A2
First Cost
0
-$110,000
-$115,000
Annual Savings
1 to Infinity
$12,500
$15,000
Explanation / Answer
USING IRR Approach
As it is mentioned in the question that IRR approach as to be used. We need to calculate IRR for infinte time period, I would suggest that we take a proxy for time period to be 100 years to be able to calculte IRR. (We are taking 100 years because after this if we cahnge time to more than 100 to any amount, the change in IRR is not very significant, and we need to proxy to be able to calculate the IRR)
The formula for IRR is:
0 = P0 + P1/(1+IRR) + P2/(1+IRR)2 + P3/(1+IRR)3 + . . . +Pn/(1+IRR)n
where P0, P1, . . . Pn equals the cash flows in periods 1, 2, . . . n, respectively; and
IRR equals the project's internal rate of return.
Now calculate IRR taking time=100 years
Project A1= 11.3634 %
Project A2 : 13.0434 %
Select Project A2 according to IRR.
Solution Using NPV approach
Now lets first find out PV of the income of both the options. As time period is infinte the PV of income from year 1 to infinity is
PV = Annual Saving/i (MARR)
In Case A1 : 12500/0.1 = 125,000
Case A2 : 15000/0.1 = 150,000
Subtract the First cost :
A1 : 125000-110,000= 15,000
A2: 150,000 - 115,000= 35,000
A2> A1 , thus A2 is better option. Selct A2
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