A heat exchanger is being installed as part of a plant modernization program. It
ID: 1242443 • Letter: A
Question
A heat exchanger is being installed as part of a plant modernization program. It costs $80,000, including installation, and is expected to reduce the overall plant fuel cost by $20,000 per year. Estimates of the useful life of the heat exchanger range from an optimistic 12 years to a pessimistic 4 years. The most likely value is 5 years. Assume the heat exchanger has no salvage value at the end of its useful life. Interest rate is 10%. Use the range of estimates to compute the mean life and determine the net present worth (NPW).Explanation / Answer
Net present value is a way to project the value of money in the present to the value of money in the future. Since money we have at the present can be invested at earn interest, it is said to be worth more now than the exact same amount in the future. This is known as the time value of money, a commonly applied idea in finance and economics. Since there is no way to accurately guess the overall return on an investment, calculations as to future value will be imperfect, but they are a useful for thinking about money growth. Use of Net Present Value Net present value is a calculation used by companies to assess weather certain uses of capital are worthwhile, or weather that capital would be better off invested. The formula for net present value is: Rt/(1+i)^t, where t is time, i is the interest rate that could be gained from investing the money, and Rt is the difference between cash inflow and outflow at time t. Essentially, if a company is planning to take a on a new project, whose cash flows will result in a negative net present value, it means the company would be better off investing the money than starting the new project. If the project has positive net present value, it might be worth pursuing, although other projects could be more profitable.