Question

You are evaluating two different silicon wafer milling machines. The Techron I costs $252,000, has a 3-year life, and has pretax operating costs of $67,000 per year. The Techron II costs $440,000, has a 5-year life, and has pretax operating costs of $40,000 per year. For both milling machines, use straight-line depreciation to zero over the project’s life and assume a salvage value of $44,000. If your tax rate is 23 percent and your discount rate is 12 percent, compute the EAC for both machines.

Answer 1

We will need the aftertax salvage value of the equipment to compute the EAC. Even though the equipment for each product has a different initial cost, both have the same salvage value. The aftertax salvage value for both is:

Aftertax salvage value = $44,000(1 − 0.23) = $33,880

To calculate the EAC, we first need the OCF and NPV of each option. The OCF and NPV for Techron I is:

OCF = −$67,000(1 − 0.23) + 0.23($252,000/3) = −$32,270

NPV = −$252,000 − $32,270 (PVIFA_12%,3) + ($33,880/1.12³) = −$305,392

EAC = −$305,392 / (PVIFA12%,3) = −$127,150

And the OCF and NPV for Techron II is:

OCF = −$40,000(1 − 0.23) + 0.23 ($440,000/5) = -$10,560

NPV = −$440,000 - $10,560(PVIFA12%,5) + ($33,880/1.12⁵) = −$458,842

EAC = −$458,842 / (PVIFA12%,5) = −$127,287

The two milling machines have unequal lives, so they can only be compared by expressing both on an equivalent annual basis, which is what the EAC method does. Thus, you prefer the Techron I because it has the lower (less negative) annual cost