A consultancy calculates that it can supply crude oil assaying services to a small oil producer for $120,000 per year for five years.There are some upfront costs the consultancy will require the oil producer to absorb.What is the maximum that these upfront costs could be,if the equivalent annual annuity to the oil company is to be under $150,000,given that the cost of capital is 10%?

Question

Quizplus · Accepted Answer

Firstly, let us calculate the equivalent annual annuity (EAA) for the oil company based on the given information:

EAA = Annual payment - Annualized upfront costs

We know that the annual payment is $120,000 per year for 5 years, which is a total of $600,000.

Now, we need to find the maximum upfront costs that the oil producer can absorb such that the EAA is under $150,000. To find this, we can use the formula:

Upfront costs = (Annual payment - EAA) / PVIFA(rate, time)

PVIFA is the Present Value Interest Factor for an Annuity, which can be found in tables or calculated using financial calculators or Excel functions. For a rate of 10% and a time of 5 years, PVIFA is 3.791.

Substituting the values:

Upfront costs = (600,000 - 150,000) / 3.791
Upfront costs = $113,724

Therefore, the maximum upfront costs that the oil producer can absorb is $113,724, which is option B.

A Consultancy Calculates That It Can Supply Crude Oil Assaying