An asset under your management, with an estimated design life of 16 years, cost $8,600,000 to purchase

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Question:

An asset under your management, with an estimated design life of 16 years, cost $8,600,000 to purchase and install. It has a revenue stream of $2,400,000 per year for each full year of operation.

Costs of operation and maintenance of this asset are as follows:
• $800,000 per year for Years 1 to 5 of the life of the asset
• $850,000 per year for Years 6 to 11 of the life of the asset
• $950,000 per year for years 12 to 15 of the life of the asset
• $1,000,000 for year 16 of the life of the asset.
As the asset is currently 14 years old, and there is a lead time of twelve months for ordering and installing a new asset, or undertaking rehabilitation, a decision needs to be made soon with respect to the best option for its ongoing use. Condition monitoring information confirms that the asset is nearing the end of its design life and should be replaced once that life is reached.
The replacement process will take about six months and commence at the end of the design life of the old asset. While the old asset will remain partially in service over the replacement period, revenue during the year in which the replacement is being undertaken (Year 1 of the replacement asset’s life) will reduce to $1,300,000.
The residual (scrap) value of the replaced asset is $2,200,000. It will cost $900,000 to remove the asset from service when it is replaced.
The asset can be rehabilitated and upgraded at the end of 16 years of service. The opportunity will be taken to improve the technology of the asset and to enhance the capacity of the asset.
This process is expected to cost $10,700,000 and be completed within one year, during which the old asset will continue to remain in reduced service. The upgraded asset is then expected to last for 16 years from the commencement of the rehabilitation process).
Costs of operation and maintenance of the rehabilitated and upgraded asset are expected to be as follows:
• $550,000 for Year 1 of the life of the upgraded asset (i.e., the year in which rehabilitation takes, as there will still be some maintenance required for the existing asset, which will remain partially in service during this period)
• $1,000,000 per year for Years 2 to 7 of the life of the upgraded asset
• $2,200,000, which includes refurbishment work, in Year 8 of the life of the upgraded asset
• $1,200,000 per year for Years 9 to 14 of the life of the upgraded asset
• $1,500,000 per year for Years 15 and 16 of the life of the upgraded asset.
The upgraded asset is expected to have a revenue stream of $3,100,000 per year, except in Year 1, when the upgrade process takes place.
The complexities of the rehabilitation and upgrading process mean that while the asset will continue to operate during the upgraded, there will be some there will be considerable service reduction during the rehabilitation and upgrading process. This revenue is expected to be $1,600,000 only, applicable to the first year of operation of the rehabilitated and upgraded asset only.
At the end of the life (16 years) of the rehabilitated and upgraded asset, it must be replaced by a completely new asset. The costs incurred for this replacement are expected to be incurred by the new asset and are therefore not to be considered in the analysis process.
Funds are available for whatever option is selected.
Your task
i. Assess the best option between replacing and rehabilitating this asset.
Money costs 7.0% per annum. Assume zero inflation.
Use at least two methods of comparing alternatives, including net present value.
ii. Comment on your answer. Include in your comments an assessment of the advantages and disadvantages of each method you use to compare alternatives.

iii.	Conduct a sensitivity analysis using different values of the discount rate, using the discount rates of 4% per annum, 7% per annum, 12% per annum and at least one (1)
other discount rate.	(20 marks)

iv.	Draw your results on a graph showing net present value of each of replacement of the asset and rehabilitation of the asset against discount rate.

v. Determine the discount rate at which the choice between replacement and rehabilitation of the asset after its life of 16 years would be indifferent.
vi. Consider (in about 300 to 400 words) your opinion of the role of the discount rate and other factors in the assessment of asset development and management projects. Use references to support your discussion.
Topics to consider include:
• The importance of selecting the most suitable discount rate in comparing two projects on a life cycle basis, including an assessment of the discount rate at which neither project is economically viable.
• The role of non-economic factors in the asset development and management decision-making process, such as risk, and environmental and social factors.