Question

Problem 2

John’s Pancake House needs to buy a new grease trap owing to changes in environmental laws. He is currently considering two different traps. Trap A costs $4000. It has a capacity of 500 gallons of grease. The operating costs of this trap are $700 per year. The trap is expected to last 4 years. Trap B costs $4000. Its capacity is 1000 gallons of grease. Annual operating costs for Trap B are $1000. When a grease trap is full it will have to be replaced (there is no salvage value). John does not foresee any more changes in the environmental laws or changes in grease trap technology. The Pancake House faces a 40% corporate tax rate and the rate of depreciation (i.e. the CCA rate) is 50% for both traps.

a. Estimate the expected useful life of grease trap B.

b. If the appropriate discount rate is 10%, which trap should John choose?

Answer 1

Part a:

Capacity of Trap A = 500 gallons

Useful life of Trap A = 4 years

Capacity of Trap B = 1000 gallons

Expected useful life of Trap B = 4 years * 2 i.e. 8 years (trap are replaced once they reach their full capacity)

Part b:

Since Trap A & B have unequal lives, hence we shall use Equivalent Annual Annuity approach for identification of trap to be used.

Depriciation schedule:

Since EAA of Trap B ($1,723.98) < EAA of Trap A ($2,285.89), hence John should choose Trap B.