Question

A production facility is currently utilizing carbon steel tubing. The current process requires injection of chemicals to control tubing corrosion due to high temperatures, pressure, and corrosive chlorides in the product flow. This injection process is estimated to cost the company $600,000 next year (at the end of year 1). This year 1 amount would escalate 5% per year over the next 5 years (years 2 through 6). The escalation in price behaves just like compound interest accruing on the previous years amount each subsequent year. Assume a zero salvage value of the carbon steel tubing at the end of the 6-year service period.

Year 1 = 600,000
Year 2 = 600,000(1.05)=630,000
Year 3 = 630,000(1.05) = 661,500
Etc.

It is proposed to replace the carbon steel that cost $32 per foot 1 year ago with chrome stainless steel tubing that would cost $80 per foot today at time zero. It is estimated that 20,000 feet of new replacement tubing would be required and installation costs for the new stainless will total $750,000. Assume the installation cost would also be at time zero. Replacing the carbon steel tubing with the stainless would eliminate the need for any injection costs since no corrosion is thought to occur with the new pipe. Neglect any potential salvage value on the stainless tubing.

Assume a MONTHLY .9490% minimum rate of return (compounded monthly), and calculate the present worth cost (PWC) today (time zero) for each option. After interpreting your cost results, compute the incremental cash flows and calculate the incremental NPV of choosing the stainless option. Interpret all of your calculations

Answer 1

	Monthly rate =		0.949%
	Annual Rate =	(1.00949 ^ 12)	1.120	12%
(i)	Cost -
(a)	Carbon steel tubing -
	Years	Cost	PV Factor @ 12%	PV of cost
	1	600000	0.892857	535714.3
	2	630000	0.797194	502232.1
	3	661500	0.71178	470842.6
	4	694575	0.635518	441415
	5	729303.8	0.567427	413826.5
	6	765768.9	0.506631	387962.4
				2751993
	Cost already incurred is a sunk cost and is therefore ignored.
(b)	Chrome stainless steel tubing -
	Cost of tube =		80 x 20000 =		1600000
	Installation cost =				750000
		PV of cost			2350000
(ii)	Incremental cosh flows =
	Pv of cost of injection saved =				2751993
	Cost of installing new tubing =				2350000
	NPV =				401992.9
	Here NPV is Positive therefore the tube should be replaced.
	Please provide feedback…. Thanks in advance…. :-)