Question

The chimney of the Chemical Enginering building was built 25 years ago in today's currency for 5,000,000 TL. The economic life of this chimney is estimated to be 50 years and there is no salvage value. This damaged chimney must be strengthened or demolished and rebuilt.

3,000,000 TL is required for the strengthening of the chimney and the economic life will increase 30 years as a result of the strengthening. In this case, the annual maintenance cost of the chimney is estimated to be 250,000 TL.

If the chimney is rebuilt, 7,500,000 TL will be spent and its economic life will be 60 years. In this case, it is estimated that the annual maintenance cost of the chimney will be 100,000 TL and there will be no salvage value. It is estimated that the demolishment expenses of the old chimney will be 500,000 TL. If interest rate is 20%, as a Chemical Engineer, what kind of decision would you recommend the university to take regarding the chimney of the building?

Answer 1

Solution:

We can evaluate the decision on the basis of annaual equivalent cost of both options:

Option I-Strengthening

EAC=(Cost of option/Annuity Factor)+Annual Maintenance cost

Annuity Factor=[1-1/(1+interest rate)^no. of years]/interest rate

=[1-1/(1+0.20)^30]/0.20

=4.979

EAC=[3,000,000 TL/4.979]+250,000 TL

=852,530.63 TL

Option II-Rebuilt

Annuity Factor=[1-1/(1+0.20)^60]/0.20

=4.9999

EAC=[(7,500,000 TL+500,000 TL)/4.9999]+100,000 TL

=1700,032 TL

Since the EAC(Equivalent annual cost) is higher under option I,hence Option II(Rebuilt) is recommended.