A heat exchanger is being installed as a part of plant modernization program. It
ID: 2427499 • Letter: A
Question
A heat exchanger is being installed as a part of 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.
(a) Determine the pessimistic, most likely, and optimistic rates of return.
(b) Use the range of estimates to compute the mean life and determine the estimated before tax rate of return.
Explanation / Answer
(a) We have to calculate IRR interna;l rate of return for each of the possibilities pessimistic, most likely, and optimistic
most likely 5 yrs=
$80000=($20000)(1yr to 5 yr)/(1+r)5=7.93%
pessimistic 4 yrs =
$80000=($20000)(1yr to 4 yr)/(1+r)4=0%
optimistic 12 yrs =
$80000=($20000)(1yr to 12 yr)/(1+r)12=22.89%
(b) The range of estimates to compute the mean life and determine the estimated before tax rate of return.
Mean life of of project means how many years it takes to pay principal amount. Here mean life of prject is 4 yrs( pessimestic) as $80,000 investment is recoverd within 4 year($20000*4) and accordingly the estimated before tax rate of return is 0%.