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MEL203 (Manufacturing with Non-metallic Materials): Homework 01, 15/04/2014

Due on 22/04/2014

Answer ALL of the following problems (5 points each; total 10 points).
Be brief and exactly to the point.

1. Your company needs to purchase a delivery truck. There are 2 options available: (i) Single down-payment
of INR 10,00,000; or (ii) Yearly payments of 1,50,000 for 8 years at 8% interest rate. Estimate which is the
better option to go for, and why? A table giving compound interest factors for 8% interest rate is given
below (Badiru and Omitaomu, 2007).



Solution:
Let us convert all cash flows to present terms for comparison (Note: we can also convert all cash flows to
annual or future terms; the results obtained after converting and comparing should be similar in all cases and
students are encouraged to verify this).
Total cost of option (i) = - INR 10,00,000 (already in present term since it involves a single down-payment
right now. The minus sign indicates cash outflow)
Total cost of option (ii) = - INR 1,50,000 * (P/A,i,n) = - INR 1,50,000 * (P/A, 8%, 8 yrs)
The conversion factor to find the present worth of an annual series of cash amounts for 8% interest and 8
years is read from the above table as: 5.747
Therefore, total cost of option (ii) = - INR 1,50,000*5.747 = - INR 8,62,050
Clearly, option (ii) will cost less than option (i). Hence, in this case it is preferable to pay for the truck with
yearly payments than with a single down-payment.


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2. A company needs to decide whether to perform some destructive tests on its products in-house or whether
to pay some other company to do these tests. To perform the tests in its own factory the company will need
to purchase test equipment for INR 8,00,000. The equipment has a useful life of 6 years, after which it can
be sold for an expected salvage value of INR 75,000. The employee hired to run the test equipment will be
paid INR 5,00,000 per year. Additionally, each test will involve a cost of INR 150 (for electricity, etc.). If
the company decides to outsource the tests to an outside test lab the cost will be INR 400 per test.
Considering an interest rate of 8% (see table given with previous question), how many tests must the
company perform each year in order for these 2 alternatives to break even i.e., in order to justify
performing the tests themselves instead of outsourcing?

Solution:
Let us convert all cash flows to annual terms for comparison (Note: again, we can also convert all cash flows
to present or future terms and the results obtained should be similar in all cases; however, the calculation for
this problem is easier when done in annual terms).
Let the number of tests being done per year be represented as T.
Total cost of option 1 (doing the tests in-house) = [-8,00,000 * (A/P, 8%, 6 yrs)] + [75,000 * (A/F, 8%, 6
yrs)] 5,00,000 [150 * T]
In the above equation, the 1
st
term in square brackets represents the annual equivalent of present money
spent on purchasing equipment. The 2
nd
term represents the annual equivalent of future money earned via
selling off the used equipment. The 3
rd
term is the employee salary (already in annual terms), while the 4
th

term is the additional annual cost associated with running T number of tests per year. Further, negative signs
indicate cash outflows while positive signs indicate cash inflows.
Therefore, total cost of option 1 = [-8,00,000 * 0.2163] + [75,000 * 0.1363] 5,00,000 [150T]
Total cost of option 2 (outsourcing the tests to another company) = - [400T] per year
By equating the above 2 costs to each other we can solve for value of T for which option 1 will break even
with respect to option 2.
[-8,00,000 * 0.2163] + [75,000 * 0.1363] 5,00,000 [150T] = - [400T]
Hence, T = 2651.3 = 2652 i.e., only if the company expects to conduct more than roughly 2650 tests per
year does it make sense to invest money in buying their own equipment and hiring an employee dedicated to
running the purchased equipment. If the expected number of tests to be done each year is less than this value
then its better to simply outsource the work to a different company.