An electric company must decide between two op­tions for managing the blowdown water from its cooling tower. Option 1 is to continue the lease on 50 acres of land for another 5-year period and dis­pose of the water by spray irrigation. The land­owner will move the pipe around as necessary and maintain the spray nozzles and valves. The previ­ous lease cost $125,000 per year with payments due midway through each year. Now the land­owner will require beginning of year payments of $180,000 each year. Option 2, which releases the 50 acre tract of land, involves purchasing a treatment system that will allow the recycling of most of the blowdown water. This system will have an initial cost of $1,600,000 and an AOC of $58,000 per year. How­ever, the company will save $220,000 per year

Question

be­cause it will not have to purchase as much make-up water as with option 1. At the end of 5 years, the company will be able to sell the equipment back to the local equipment supplier for 30% of the first cost. If the electric company uses a MARR of 15% per year, should it continue to lease (defender) or purchase the treatment system (challenger)?

What will be an ideal response?

Answer 1

Option 1 (lease) is defender; option 2 is challenger. Find AW of lease over 5-year period

AWD = [-180,000 -180,000(P/A,15%,4)](A/P,15%,5)
= [-180,000 -180,000(2.8550)](0.29832)
= $-207,004

AWC = -1,600,000(A/P,15%,5) -58,000 + 220,000 + (0.30)(1,600,000)(A/F,15%,5)
= -1,600,000(0.29832) + 162,000 + (480,000)(0.14832)
= $-244,118

Select option 1, continue to lease the land