A chemical plant needs to be revamped so as to continue in service for next 12 y

Question

A chemical plant needs to be revamped so as to continue in service for next 12 years. There are two options in front of the Management: Option-1 : Spend Rs 5.8 crore now for satisfactory operation of next 12 yrs. Option-II : Spend Rs 5.0 crore now and after 8 years, spend another Rs. 2.5 crore for a total satisfactory operation of 12 yrs. Which option should be selected if no inflation is considered ? If inflation at the rate of 7% (end-of-year compounding) is assumed for all future costs, then which option is more attractive ? For what rate of inflation, both the options are equally attractive ? Describe two different methods of "Depreciation" an equipment / plant may undergo (with numerical example).

Explanation / Answer

a) Since there is no inflation, passage of time does not affect the value of money. So, Option - I should be selected beacause in the other option we have to invest more money over 12 years.

b) Imagine you do not spend any money at all, and then for each option calculate the future value keeping in mind the spending amount and the rate for 12 years. The option with less future value ought to be selected because it indicates successful operation is being achieved with less investment.

c) Proceed similar to part b). Only in this case, imagine the rate to be any variable and then equate both the future values.

d.) Please follow the link for detailed examples and explanations.

http://accountinginfo.com/study/dep/

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