Question

3. A production line that must last for another 3 years will require $200,000 to upgrade. The annual cost of operating the production line will be $310,000, which is expected to be remain constant. To modify and repair the production line would cost $350,000 and has a 50% chance of reducing annual costs to S130.000. There is a 25% chance that the reduced annual costs of the modified production line will increase by 10% each year. There is a further 25% chance that the reduced annual costs will increase by 20% each year. If a 12% rate of return is required, should the modification be undertaken? One-time Modify cost Annual operating Maintenance fee cost No modification $200,000 $310.000 Modification 50% $200,000 $350,000 $130,000; 1 0% 25% $200,000 $350,000 $130,000; † 10% 25% $200,000 $350,000 $130,000: 1 20%

Answer 1

* NO MODIFICATIONS COSTS STRUCTURE: Maintenance costs $2,00,000 Year Cost PV Factor PV 1 3 ,10,000 0.892857 2,76,786 2 3,10,000 0.797194 2 ,47,130 3 3 ,10,000 0.71178 2,20,652 7,44,568 Assuming Maintenance costs are paid upfront and Annual costs are paid at the end of each year. TOTAL COSTS = 2,00,000 +7,44,568 = $9,44,568 * MODIFICATIONS COSTS STRUCTURE:- Maintenance Costs $2,00,000 Modification Costs $3,50,000 1) No increase in operating costs Year Cost PV Factor 1 1,30,000 0.892857 2 1,30,000 0.797194 3 1,30,000 0.71178 PV 1,16,071 1,03,635 92,531 3,12,238 2) 10% increase in operating costs Year Cost PV Factor 1,43,000 0.892857 - 2 1,43,000 0.797194 3 1 ,43,000 0.71178 PV 1,27,679 1,13,999 1,01,785 3,43,462 3) 20% increase in operating costs Year Cost PV Factor 1,56,000 0.892857 1,56,000 0.797194 1 1,56,000 0.71178 PV 1,39,286 1,24,362 1,11,038 3,74,686 Probability Factor =(3,12,238*0.5)+(3,43,462*0.25) + (3,74,686*0.25) Operating costs = 3,35,656 Assuming Maintenance costs & Modification Costs are paid upfront and Annual costs are paid at the end of each year. TOTAL COSTS = 2,00,000 + 3,50,000 + 3,35,656 = $ 8,85,656 So, As Modification and operating costs combined are less Hence, Modification should be undertaken and proceeded with