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 $79,000. 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 $220,000 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 $  .

The annual worth of low salvage value is $  .

Decision is  (not sensitive/sensitive) to salvage value.

Answer 1

Case of high salvage value

First Cost=Co=-$250000

AOC=R=79000

Salvage=S=$100000

MARR=i=14%

Useful life=n=3 years

AW of Cost in this option=-Co*(A/P,14%,3)-R+S*(P/F,14%,3)*(A/P,14%,3)

Let us calculate the interest factors

(P/F,0.14,3)=1/(1+0.14)^3=0.674972

AW of Cost in this option=-250000*0.430731-79000+100000*0.674972*0.430731=-157609.61

Case of high salvage value

In this case S=$10000

AW of Cost in this option=-Co*(A/P,14%,3)-R+S*(P/F,14%,3)*(A/P,14%,3)

AW of Cost in this option=-250000*0.430731-79000+10000*0.674972*0.430731=-183775.44

We find that equivalent annual cost is higher than in case of outsourcing irrespective of salvage value.

Manufacturer should go for in house facility.

Decision is not sensitive to salvage value in this case.