Question

The production manager on the Ofon Phase 2 offshore platform operated by Total S.A. must purchase specialized environmental equipment or an equivalent service. The first cost is $250,000 with an AOC of $73,000. The manager has let it be known that he does not care about the salvage value because he thinks it will make no difference in the decision-making process. His supervisor estimates the salvage might be as high as $100,000 or as low as $10,000 in 3 years, at which time the equipment will be unnecessary. Alternatively, a subcontractor can provide the service for $195,000 per year. The total offshore project MARR is 14% per year. Determine if the decision to buy the equipment is sensitive to the salvage value. The annual worth of high salvage value is $ 157181.24 The annual worth of low salvage value is $136142.96 % Decision is not sensitive to salvage value.

Answer 1

Alternate A: Salvage Value after 3 years is 100000 Case 1: Salvage Value = $100,000 after 3 years Year 1 Year 2 Year 3 Initial Cost $250,000 AOC $73,000 $73,000 $73,000 Salvage Value $100,000 Net Outflow $323,000 $73,000 ($27,000) PVF @ 14% 0.8772 0.7695 0.675 Present Value of Outflow $283,335.60 $56,173.50 ($18,225.00) Net Cost of Purchase $321,284.10 Case 2: Salvage Value = $10,000 after 3 years Year 2 Year 3 Year 1 $250,000 $73,000 $73,000 Initial Cost AOC Salvage Value Net Outflow PVF @ 14% Present Value of Outflow $323,000 $73,000 0.8772 0.7695 $283,335.60 $56,173.50 $73,000 $10,000 $63,000 0.675 $42,525.00 Net Cost of Purchase $382,034.10

Alternate B: Equivalent Service Cost = $195000 per year PV of cost = $195,000*PVAF(14%,3) = $195,000* 2.3216 = 452,712 In any case (Case 1 & 2) Alternative Ai.e to purchase the equipment is better than Alternative B for equivalent service. Hence the decision is not sensitive to Salvage Value.