Chilly county council case

1. CHILLY COUNTY COUNCIL CASE
Chilly County Council is considering installing a new central heating system in
one of its older offices. As part of its long-term plan this office will be sold in
three years’ time on 31/12/X3. The authority believes that installing the central
heating system will make the building easier to sell and add £100 000 to the final
selling price. Three systems are regarded as feasible and the estimated capital
costs ofeacharesetout here:
Gas 170000
Oil 150000
Solidfuel 140000
Annual fuel costs are dependent on the severity of the winter each year and the
rate of increase in fuel price. At the prices expected to be in force during 19X1
the annual fuel costsareestimated at:
Sever
Winter
winter
Mild
winter
Gas 40000 24000
Oil 53000 37000
Solidfuel 45000 36000
The authority estimates that in each year thereisa70% chanceofaseverewinter anda
30% chance of a mild winter. The chance of a mild or severe winter in any year is
considered to be independent of the chance of a mild or severe winter in the previous
year.
Fuel prices are expected during 19X2 and 19X3 to increase by either 8%
(probability equal to 0.4) or 10% (probability equal to 0.6). Whichever rate of
increase applies in 19X2 will be repeated the following year. Maintenance costs
(payable at the end of theyear) are expected to be:

2. Gas
Oil
Solid fuel
Maintenance costs are fixed.
There isno difference in
performance between the
systems. The authority uses the
monetary cost of capital as its
hurdle rate. This rate is currently
@12%.
Which systemshould be
purchased bytheauthority?
Your solution should use
expected value to calculate risk,
and should expressprojectcosts
inmonetaryterms,permitting
discountingusingthemonetary
costof capital.
2500
2000
10000(in19X2)