Question

You are evaluating two different machines. Machine A costs $210,000, has a three-year life and has pretax operating costs of $30,000 per year. Machine B costs $320,000, has a five-year life and has pretax operating costs of $23,000 per year. You will depreciate both machines using straight-line depreciation to a zero salvage value over the machine’s life. The expected salvage value for each machine is $20,000. If your tax rate is 40%, both machines are repeatable and your discount rate is 14%, which machine should you purchase assuming you have to purchase one of the machines?

Answer 1

As the lives of the machines are different the Equivalent annual cost has to be
found out.
EAC of Machine A:	0	1	2	3
After tax operating costs [30000*(1-40%)]		-18000	-18000	-18000
Tax shield on depreciation [(210000/3)*40%]		28000	28000	28000
After tax salvage value [20000*(1-40%)]				12000
Initial investment	-210000
Annual after tax cash flows	-210000	10000	10000	22000
PVIF at 14% [PVIF = 1/1.14^n]	1	0.87719	0.76947	0.67497	2.32163
PV at 14%	-210000	8772	7695	14849
Sum of PVs t0 to t3	-178684
EAC of Machine A = 178684/2.32163 =	$           76,965
EAC of Machine B:	0	1	2	3	4	5
After tax operating costs [23000*(1-40%)]		-13800	-13800	-13800	-13800	-13800
Tax shield on depreciation [(320000/5)*40%]		25600	28000	28000	28000	28000
After tax salvage value [20000*(1-40%)]						12000
Initial investment	-320000
Annual after tax cash flows	-320000	11800	14200	14200	14200	26200
PVIF at 14% [PVIF = 1/1.14^n]	1	0.87719	0.76947	0.67497	0.59208	0.51937	3.43308
PV at 14%	-320000	10351	10926	9585	8408	13607
Sum of PVs t0 to t3	-267123
EAC of Machine A = 267123/3.43308 =	$         -77,809
DECISION:
Machine A is to be purchased as its EAC is lower than the EAC of Machine B.