Question

Two mutually exclusive alternatives, A and B (both MACRS-GDS 5 year property), are available. Alternative A requires an original investment of $100,000, has a useful life of 6 years, annual operating costs of $2,500, and a salvage value at the end of year k given by $100,000 (0.70)^k. Alternative B requires an original investment of $150,000, has a life of 8 years, zero annual operating costs, and a salvage value at the end of year k given by $150,000(0.80)^k. The after-tax MARR is 15% and a 40% tax rate is applicable. Suppose both options involve a loan of 40% of the investment cost, the loan rate is only 2% and the payment follows Plan 1 (pay the accumulated interest at the end of each interest period and pay the principal at the end of the loan period).

Use a planning horizon of 6 years reccomend the least-cost alternative (assume Do Nothing is not possible).

Answer 1

	Alternative A		Alternative B
Original investment	100000		150000
Useful life	6		8
Annual operating costs	2500		0
Salvage value	11,667	(=100000*0.7/6)	20000	(=150000*0.8/6)
Depreciation per annum	14,722	(=Original investment – salvage value)/useful life	16,250	Since computation is only for 6 years, useful life of Alt. B is also assumed to be 6 years
Loan (40% of investment)	40,000		60,000
Interest on loan (@2%)	800		1,200
Let us calculate net cash outflow each year. It is to be noted that the cash outflow would be net of cash saved due to lower tax. In absence of these expenditures, tax expense would have been higher. Depreciation is a non cash item yet tax is saved on it.
	Alternative A		Alternative B
Cash Expenditure:
Interest on loan	800		1,200
Operating expenses	2500		-
	3,300		1,200
Tax savings (on cash plus non cash depreciation expense at 40%)	7,209		6,980
Net cash savings	3,909		5,780
Year	Alternative A	PV @ 15% MARR	Alternative B
Year 0: Original investment	-100000	1.0000	-150000
Year 1	3,399	0.8696	5,026
Year 2	2,956	0.7561	4,371
Year 3	2,570	0.6575	3,800
Year 4	2,235	0.5718	3,305
Year 5	1,943	0.4972	2,874
Year 6	1,690	0.4323	2,499
Year 6: Scrap value	5,044	0.4323	8,647
Net expenses PV at the end of 6 years	(80,163)		(119,479)

Thus, at the end of the 6 year period, Alternative A offers lower cost