Question

Vandalay Industries is considering the purchase of a new machine for the production of latex. Machine A costs $2,230,000 and will last for 7 years. Variable costs are 35 percent of sales, and fixed costs are $123,000 per year. Machine B costs $4,680,000 and will last for 10 years. Variable costs for this machine are 28 percent of sales and fixed costs are $84,000 per year. The sales for each machine will be $9.36 million per year. The required return is 10 percent and the tax rate is 35 percent. Both machines will be depreciated on a straight-line basis.

(a) If the company plans to replace the machine when it wears out on a perpetual basis, what is the EAC for machine A? (Do not round your intermediate calculations.)

(b) If the company plans to replace the machine when it wears out on a perpetual basis, what is the EAC for machine B?

Answer 1

Solution:

Since we need to calculate the EAC for each machine, sales are irrelevant. EAC only calculates the costs of operating the equipment,not the sales. Using the bottom up approach, or net income plus depreciation, method to calculate OCF, we get:

		Machine A		Machine B
Variable Costs		-$3,276,000		-$2,620,800
Fixed Costs		-$123,000		-$84,000
Depriciation		-$318,571		-$468,000
EBT		-$3,717,571		-$3,172,800
Tax		$1,301,150		$1,110,480
Net Income		-$2,416,421		-$2,062,320
(Add) Depriciation		$318,571		$468,000
OCF		-$2,097,850		-$1,594,320

The NPV and EAC for Machine A is:

NPV_A= –$2,230,000 – $2,097,850(PVIFA10%,7)

NPV_A= –$12,443,173

EAC_A= –$12,443,173 / (PVIFA10%,7)

EAC_A= –$2,555,906

And the NPV and EAC for Machine B is:

NPV_B= –$4,680,000 – $1,594,320(PVIFA10%,10)

NPV_B= –$14,476,459

EACB= –$14,476,459 / (PVIFA10%,10)

EACB= –$2,355,964