Question

Bridgton Golf Academy is evaluating new golf practice equipment. The "Dimple-Max" equipment costs $146,000, has a 4-year life, and costs $10,300 per year to operate. The relevant discount rate is 12 percent. Assume that the straight-line depreciation method is used and that the equipment is fully depreciated to zero. Furthermore, assume the equipment has a salvage value of $10,700 at the end of the project’s life. The relevant tax rate is 21 percent. All cash flows occur at the end of the year. What is the equivalent annual cost (EAC) of this equipment?

Answer 1

Equivalent Annual Cost (EAC) for the equipment

Initial Investment Cost

Initial Investment Cost = $146,000

Annual Operating Cash Flow (OCF)

Operating Cash Flow (OCF) = Pretax Cost(1 – Tax Rate) + (Depreciation x Tax Rate)

= [−$10,300(1 − 0.21)] + [($146,000 / 4 Years) x 0.21]

= [-$10,300 x 0.79] + [$36,500 x 0.21]

= -$8,137 + $7,665

= -$472

Cash flow in year 4

Cash flow in year 4 = Annual operating cash flow + After-tax salvage value

= -$472 + [$10,700 x (1 – 0.21)]

= -$472 + [$10,700 x 0.79]

= -$472 + $8,453

= $7,981

Net Present Value of the Project

Period	Annual Cash Flow ($)	Present Value factor at 12%	Present Value of Cash Flow ($)
1	-472	0.892857	-421.43
2	-472	0.797194	-376.28
3	-472	0.711780	-335.96
4	7,981	0.635518	5,072.07
TOTAL		3.037349	3,938.41

Net Present Value (NPV) = Present Value of annual cash inflows – Initial Investment

= $3,938.41 - $146,000

= -$142,061.59

Equivalent Annual Cost (EAC)

Equivalent Annual Cost (EAC) = Net Present Value / [PVIFA 12%, 4 Years]

= -$142,061.59 / 3.037349

= -$46,771.57 (Negative)

“Therefore, the equivalent annual cost (EAC) of this equipment will be -$46,771.57 (Negative)”

NOTE    

The Formula for calculating the Present Value Factor is [1/(1 + r)ⁿ], Where “r” is the Discount/Interest Rate and “n” is the number of years.