Question

Blooper Industries must replace its magnoosium purification system. Quick & Dirty Systems sells a relatively cheap purification system for $10 million. The system will last 5 years. Do-It-Right sells a sturdier but more expensive system for $16 million; it will last for 8 years. Both systems entail $1 million in operating costs; both will be depreciated straight-line to a final value of zero over their useful lives; neither will have any salvage value at the end of its life. The firm’s tax rate is 30%, and the discount rate is 15%. Either machine will be replaced at the end of its life.

a. What is the equivalent annual cost of investing in the cheap system? (Do not round intermediate calculations. Enter your answer as a positive value. Enter your answer in millions rounded to 3 decimal places.)

b. What is the equivalent annual cost of investing in the more expensive system? (Do not round intermediate calculations. Enter your answer as a positive value. Enter your answer in millions rounded to 3 decimal places.)

Answer 1

Quick & Dirty
Year	0	1	2	3	4	5
Depreciation		2.00	2.00	2.00	2.00	2.00
Less:Tax shield		0.60	0.60	0.60	0.60	0.60
Add: operating costs		1.00	1.00	1.00	1.00	1.00
Less: tax saved		0.30	0.30	0.30	0.30	0.30
Add: initial cost	10
Net Cash out flow	10.00	0.10	0.10	0.10	0.10	0.10
NPV @ 15%	10.34
Equivalent annual cost	$3.083
Do it Right
Year	0	1	2	3	4	5	6	7	8
Depreciation		2.00	2.00	2.00	2.00	2.00	2.00	2.00	2.00
Less:Tax shield		0.60	0.60	0.60	0.60	0.60	0.60	0.60	0.60
Add: operating costs		1.00	1.00	1.00	1.00	1.00	1.00	1.00	1.00
Less: tax saved		0.30	0.30	0.30	0.30	0.30	0.30	0.30	0.30
Add: initial cost	16
Net Cash out flow	16.00	0.10	0.10	0.10	0.10	0.10	0.10	0.10	0.10
NPV @ 15%	16.45
Equivalent annual cost	$3.666