Question

Leonard, a company that manufactures explosion-proof motors, is considering two alternatives for expanding its international export capacity. Option 1 requires equipment purchases of $700,000 now and $400,000 two years from now, with annual M&O costs of $50,000 in years 1 through 10. Option 2 involves subcontracting some of the production at costs of $200,000 per year beginning now through the end of year 10. Neither option will have a significant salvage value. Use a present worth analysis to determine which option is more attractive at the company's MARR of 10% per year. The present worth of option 1 is $ and that of option 2 is $ 7.

Answer 1

Option 1

Initial cost = $700,000

Cost two years from now = $400,000

Annual M&O costs = $50,000

Useful period = 10 years

MARR = 10%

Calculate the present worth of option 1 -

PW = -Initial cost - Cost two years from now (P/F, i, n) - Annual M&O cost(P/A, i, n)

PW = -700,000 - 400,000(P/F, 10%, 2) - 50,000(P/A, 10%, 10)

PW = -700,000 - [400,000 * 0.8264] - [50,000 * 6.1446]

PW = -700,000 - 330,560 - 307,230

PW = -1,337,790

The present worth of Option 1 is $ - 1,337,790.

Option 2

Annual subcontracting cost = $200,000

Useful period = 10 years

MARR = 10%

Calculate the present worth of Option 2 -

PW = -Annual subcontracting cost (P/A, i, n)

PW = -200,000 (P/A, 10%, 10)

PW = -200,000 * 6.1446

PW = -1,228,920

The present worth of Option 2 is $ - 1,228,920.

The present worth of Option 2 is numerically higher.

So, Option 2 is more attractive to the company.