Question

You are working for Microsoft and have been given the responsibility to choose between two equipment. Equipment A costs $398,000 and requires $113,000 in pretax annual operating costs. Equipment B costs $510,000 and requires $67,000 in pretax annual operating costs. Equipment A has a life of 5 years and Equipment B has a life of 4 years Both equipment will be depreciated using the straight-line method to zero over its life. Neither equipment will have any salvage value. Whichever equipment is selected, it will never be replaced. The discount rate is 12 percent and the tax rate is 34 percent. Which Equipment should be purchased and why?

• Equipment A because its NPV is about $61,927 higher than Equipment B's NPV

• Equipment B because its NPV is about $56,642 higher than Equipment A's NPV

• Equipment A because its equivalent annual cost (EAC) is about $38,319 higher than Equipment B's EAC

• Equipment B because its NPV is about $45,880 higher than Equipment A's NPV

Answer 1

For Equipment A

Annual Depreciation = $398000/5 = $79600

Annual Tax savings due to depreciation = $79600*0.34 = $27064

Annual After tax operating costs = $113000 *(1-0.34) = $74580

Net After tax annual cost = $74580-$27064 =$47516

So, NPV = -398000 - 47516/0.12*(1-1/1.12^5) = -$569284.55

EAC = -569284.55*0.12/(1-1/1.12^5) = -$157925.07

For Equipment B

Annual Depreciation = $510000/4 = $127500

Annual Tax savings due to depreciation = $127500*0.34 = $43350

Annual After tax operating costs = $67000 *(1-0.34) = $44220

Net After tax annual cost = $44220-$43350 =$870

So, NPV = -510000 - 870/0.12*(1-1/1.12^4) = -$512642.49

EAC = -512642.49*0.12/(1-1/1.12^4) = -$168779.56

As the equipment is not to be replaced, the NPV is the correct criteria to choose

As equipment B's NPV is less negative by an amount of ($569284.59-512642.49) = $56642, we should select equipment B .

2nd option - Equipment B because its NPV is about $56,642 higher than Equipment A's NPV is correct