W5_HYCIENTH_Purchase of a Pumping Unit

1.  Problem Recognition, Definition and Evaluation

A firm is e evaluating the purchase of one of two pieces of crude pumping unit. Unit A has a purchase price of $10,000 with a four-year life and zero salvage value. Annual maintenance costs are $500 per year. Unit B has a purchase price of $20000 with a twelve-year life and $5,000 salvage value. In year 1, maintenance costs are zero. In Year 2 maintenance costs are $100 and increases by $100 per year thereafter. The firm’s cost of capital is 8 percent.

2.  Development of Feasible Alternatives

In selecting a crude pumping unit, factors that need to be considered are

1. The terrain the pumps will be working in (swamp, desert or hilly areas),

2. The volume of crude to be pumped,

3. Maintenance cost for the pumps – is it a steady cost increase or a gradient year to year increase,  and

4. Safety features/operating envelope defined by the firm as acceptable for insurance and legal reasons.

3.  Development of the outcomes for each alternative

 Assume both Unit A and Unit B both has same service conditions.

Unit A and B have a live span of 4 years and 12 years respectively. Selecting a common multiple, this in this case will be 12 years.

Present Worth, P =F (1+I)^-n

Where:

                  P = present value or present worth

                  F = future value or future worth

                  A= annual amount or annuity

n = number of compounding periods or asset life

                  I = interest rate

                 

4.  Selection of a Criteria

Since cost and not benefit is being analysed here, the unit with the lower Net Present Worth cost structure is preferable.

5.  Analysis and Comparison

NPW Unit A:

NPW         = $10,000 + $10,000(P/F,8%,4) + $10,000(P/F,8%,8) + $500(P/A,8%,12)

                  = $10,000 + $10,000(0.7350) + $10,000 (0.5403) + $500(7.536)

                  = $26,521

           

NPW Unit B:

NPW         = $20,000 + $10,000(P/G,8%,12) - $5000(P/F,8%,12) - $100

                  = $20,000 + $100(34.634) - $5000 (0.32971) - $100

                  = $21,347

6.  Selection of the Preferred Alternative

Since Unit B at @ $21,347 < $26,521 for Unit A, Unit B is the preferred option.

7.  Performance Monitoring & Post Evaluation of Results

The alternatives under consideration have different costs and benefits over the analysis period.

If the calculation involves benefits greater than costs, then Unit A with the higher benefit NPW would be preferred.

8.  Reference:

1.     Sullivan, W. G., Wicks, E.M., & Koelling, C.P. (2012). Engineering Economy (15th ed.), Chapter 14, New Jersey, NJ. Pearson Higher Education, Inc.

2.     Amos, J. S. et al. (2012). Skills &Knowledge of Cost Engineering (5th  ed), AACE International, Morgantown, USA.