Question

LODH Company, must install safety devices throughout its plant or it will lose its insurance coverage. Two alternatives are acceptable to the insurer. The first costs $400 000 to install and $80 000 to maintain annually. The second costs $600 000 to install and $40 000 to maintain annually. Each has a 10-year income tax life and a 10-year useful life. LODH’s discount rate is 12 per cent, its marginal tax rate is 30 per cent and it uses straight-line depreciation.

Answer 1

1. Annuity factor for 10 years@12%= 5.6502.

Thus 80000 annually maintainable cost = 80000× 5.6502 = $ 452016.

Cost = $ 400000 and useful life is 10 years hence annual depreciation =$ 40000.

Thus present value of depreciation = 40000 × 5.6502= $ 226008

Total annual cost at present value = 226008+452016 = $ 678024.

Tax benefits can be taken from the annual cost = 678024 × 30% = 203407.

Thus net annual cost = 678024 - 203407 = $ 474617.

Thus actual total cost at present value = 474617+40000 = 847617.

2. Annual maintainance cost = $ 40000.

Present value of maintainance cost = $ 40000 × 5.6502 = $226008.

Cost = 600000 and useful life is 10 years hence depreciation per year = $60000.

Present value of depreciation= 60000 × 5.6502 =. $ 339012.

Total maintain and depreciation cost at present value =226008 + 339012 = 565020.

Tax benefits taken from annual cost = 565020 × 30%. = $ 169506.

Thus net annual cost at present value= 565020- 169506 = $395514.

Thus actual total cost at present value = 600000+3995514 = $ 995514.

Hence LODH company shoul consider 1st option as it will have minimum cost over the period of assets Operations.