Question

You are evaluating two different milling machines. The Techron I costs 210,000, has a three year life, and pretax operating costs of 34,000 per year. The Techron II costs 320,000, lasts five years, and has pretax operating costs of 23,000 per year. Assume both machines can be depreciated using the straight-line method and both machines will have a salvage value of 20,000. The company tax rate is 35% and the discount rate is 12%. Which machine should you purchase?

Answer 1

As the lives of the two machines are different, the
annual worth cost should be calculated:
TECHRON I:
Annual worth of first cost = -210000*0.12*1.12^3/(1.12^3-1) =	$          -87,433
AW of after tax operating costs = 34000*(1-35%) =	$          -22,100
AW of depreciation tax shield = (210000-20000)*35%/3 =	$           22,167
AW of salvage value = 20000*0.12/(1.12^3-1) =	$ 5,927
AW cost	$          -81,440
TECHRON II:
Annual worth of first cost = -320000*0.12*1.12^5/(1.12^5-1) =	$          -88,771
AW of after tax operating costs = -23000*(1-35%) =	$          -14,950
AW of depreciation tax shield = (320000-20000)*35%/5 =	$           21,000
AW of salvage value = 20000*0.12/(1.12^5-1) =	$ 3,148
AW cost	$          -79,573
DECISION:
As the AW cost of Techron II is lower, it should be
purchased.