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Ellay steel corp. is evaluating two different steel bending machines using its WACC of 7.5%. Machine...

Ellay steel corp. is evaluating two different steel bending machines using its WACC of 7.5%. Machine A costs $320,000, has a three-year life, and has pre-tax operating costs of $83,000 per year. Machine B costs $495,000, has a five-year life, and has pre-tax operating costs of $42,000 per year. Both bending machines are in Class 8 (CCA rate of 20% per year). Recall that Ellay’s tax rate is 35%.

Assume that there is no salvage value for both machines and compute the EAC for each one.
Which one would be chosen by Ellay corp? Why?

Expert Solution

Ellay steel corp. is evaluating two different steel bending machines using its WACC of 7.5%. Machine A costs $320,000, has a three-year life, and has pre-tax operating costs of $83,000 per year. Machine B costs $495,000, has a five-year life, and has pre-tax operating costs of $42,000 per year. Both bending machines are in Class 8 (CCA rate of 20% per year). Recall that Ellay’s tax rate is 35%.

00001. Assume that there is no salvage value for both machines and compute the EAC for each one.

00002. Which one would be chosen by Ellay corp? Why?

EAC = Present value of cash flow / PV of annuity $1 factor discounted

So first calculate Present value of cash flow

Machine A costs $320,000,

Dep = 320000 / 3 = 106666.67

Tax shield = 106666.67 * 20% = 21333

year	Operating cost	Tax benefits	Add back depreciation tax shield	Net CF (outflow)	PV of cash flow @ 7.5%
1	83000	29050	21333	75283	75283*0.9302 =70030.69
2	83000	29050	21333	75283	75283*0.8653 =65145
3	83000	29050	21333	75283	75283*0.805 =60599.85

Total PV of cash flow = 70030.69 + 65145 + 60599.85 =195775.37 + 320000 = 515775.7

PV of annuity due $1 @ 7.5% for 3 period = (1/1+7.5%)3GT =2.6005

EAC = 515775.7 / 2.6005 = 198337

Machine B costs $495,000

Dep = 495000 / 5 = 99000

Tax shield = 99000 * 20% = 19800

Annual cash flow =

Pre tax cost = 42000

Tax benefit = 14700

Dep tax shield = 19800

Net cash flow = - 7500

PV of cash flow = 7500 * ( 1 / 1 + 7.5%)5GT

PV of cash flow = 7500 * 4.046 = 30344

EAC = 30344 + 495000 / 4.046 = 525344 / 4.046

EAC = 129843

Machine B are used for the project, because it has the lowest EAC

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