A company is considering the installation of heat recovery equipment in a refini

Question

A company is considering the installation of heat recovery equipment in a refining

operation to reduce steam operating costs from $770,000 to $660,000 in year 1, and from

$800,000 to $630,000 in years 2 through 5. The heat recovery equipment will cost

$500,000 now (year 0), with an expected salvage value of $120,000 in five years. The

minimum rate of return imin = 10% before taxes. Use NPV or incremental NPV before tax

analysis to determine if the heat recovery equipment should be installed from an

economic viewpoint. Show any cash flow timelines used, and label all discount factors

used (P/F, F/P, P/A, A/P, F/A, A/F)i%,n years

Explanation / Answer

ANSWER:

Benefit in year 1 = steam operating costs in year 1 before installation - steam operating costs in year 1 after installation = $770,000 - $660,000 = $110,000

Benefit from year 2 to year 5 = steam operating costs in year 2 to 5 before installation - steam operating costs in year 2 to 5 after installation = $800,000 - $630,000 = $170,000

initial investment = $500,000

npv = initial investment + benefit in year 1(p/f,i,n) + benefits from year 2 to 5(p/a,i,5) - benefits from year 2 to year 5(p/a,i,1)

i = 10%

npv = -500,000 + 110,000(p/f,10%,1) + 170,000(p/a,10%,5) - 170,000(p/a,10%,1)

npv = -500,000 + 110,000 * 0.9091 + 170,000 * 3.791 - 170,000 * .909

npv = -500,000 + 100,001 + 644,470 - 154,530

npv = $89,941

so the net present value is $89,941 and therefore from economic point of view investment is ok.

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