Question

Franklin Company is analyzing two machines to determine which one it should purchase. Whichever machine is purchased will be replaced at the end of its useful life. The company requires a 12 percent rate of return and uses straight-line depreciation to a zero book value over the life of the machine. Machine A has a cost of $372,000, annual operating costs of $31,600, and a 4-year life. Machine B costs $268,000, has annual operating costs of $39,200, and a 3-year life. The firm currently pays no taxes. Which machine should be purchased and why? Machine A; because it will save the company about $2,875 a year Machine A; because it will save the company about $4,130 a year Machine B; because it will save the company about $3,294 a year Machine B; because it will save the company about $2,795 a year Machine B; because it will save the company about $2,358 a year

Answer 1

Machine A

Time line		0	1	2	3	4
Cost of new machine		-372000
=Initial Investment outlay		-372000
Sales			0	0	0	0
Profits	Sales-variable cost		0	0	0	0
Operating cost			-31600	-31600	-31600	-31600
-Depreciation	Cost of equipment/no. of years		-93000	-93000	-93000	-93000
=Pretax cash flows			-124600	-124600	-124600	-124600
-taxes	=(Pretax cash flows)*(1-tax)		-124600	-124600	-124600	-124600
+Depreciation			93000	93000	93000	93000
=after tax operating cash flow			-31600	-31600	-31600	-31600
+Tax shield on salvage book value	=Salvage value * tax rate					0
=Terminal year after tax cash flows						0
Total Cash flow for the period		-372000	-31600	-31600	-31600	-31600
Discount factor=	(1+discount rate)^corresponding period	1	1.12	1.2544	1.404928	1.5735194
Discounted CF=	Cashflow/discount factor	-372000	-28214.29	-25191.33	-22492.26	-20082.37
NPV=	Sum of discounted CF=	-467980.24

EAC	-154075.2105
Year or period		0	1	2	3	4
EAC			-154075.2	-154075.2	-154075.2	-154075.2
Discount factor=	(1+discount rate)^corresponding period		1.12	1.2544	1.404928	1.5735194
Discounted CF=	Cashflow/discount factor		-137567.2	-122827.8	-109667.7	-97917.58
NPV=	-467980.24
EAC is equivalent yearly CF with same NPV =	-154075.2105

Machine B

Time line		0	1	2	3
Cost of new machine		-268000
=Initial Investment outlay		-268000
						100.00%
Sales			0	0	0
Profits	Sales-variable cost		0	0	0
Operating cost			-39200	-39200	-39200
-Depreciation	Cost of equipment/no. of years		-89333.33	-89333.33	-89333.33	0	=Salvage Value
=Pretax cash flows			-128533.3	-128533.3	-128533.3
-taxes	=(Pretax cash flows)*(1-tax)		-128533.3	-128533.3	-128533.3
+Depreciation			89333.333	89333.333	89333.333
=after tax operating cash flow			-39200	-39200	-39200
+Tax shield on salvage book value	=Salvage value * tax rate				0
=Terminal year after tax cash flows					0
Total Cash flow for the period		-268000	-39200	-39200	-39200
Discount factor=	(1+discount rate)^corresponding period	1	1.12	1.2544	1.404928
Discounted CF=	Cashflow/discount factor	-268000	-35000	-31250	-27901.79
NPV=	Sum of discounted CF=	-362151.79

Year or period		0	1	2	3
EAC			-150781.5	-150781.5	-150781.5
Discount factor=	(1+discount rate)^corresponding period		1.12	1.2544	1.404928
Discounted CF=	Cashflow/discount factor		-134626.4	-120202.1	-107323.3
NPV=	-362151.79
EAC is equivalent yearly CF with same NPV =	-150781.5286

EAC B-EAC A = -150781.5286+154075.2105

=

3293.6819

Machine B; because it will save the company about $3,294 a year