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Assume that you have been invited by Letang Industrial Systems Company (LISC) to advise them in deciding between two different conveyor belt systems. System A costs $265,000, has a four-year life, and requires $73,000 in pretax annual operating costs. System B costs $345,000, has a six-year life, and requires $67,000 in pretax annual operating costs. Both systems are to be depreciated straight-line to zero over their lives and will have zero salvage value. Whichever project is chosen, it will not be replaced when it wears out. If the tax rate is 21 percent and the discount rate is 8 percent, which project should the firm choose?
Calculation of EAC of System A | |||||||
Particulars | 0 | 1 | 2 | 3 | 4 | ||
Initial Investment | |||||||
Cost of system (A) | -265000 | ||||||
Operating Cash Flows | |||||||
Operating costs (B) | -73000 | -73000 | -73000 | -73000 | |||
Depreciation (C ) ($265,000 / 4 years) |
-66250 | -66250 | -66250 | -66250 | |||
Total Expenses (D = B+C) | -139250 | -139250 | -139250 | -139250 | |||
Tax @21% (E = D*21%) | -29242.5 | -29242.5 | -29242.5 | -29242.5 | |||
Expenses after tax (F = D-E) | -110007.5 | -110007.5 | -110007.5 | -110007.5 | |||
Add back Depreciation (G = -C) | 66250 | 66250 | 66250 | 66250 | |||
Net Operating Cash Flows (H = F+G) | -43757.5 | -43757.5 | -43757.5 | -43757.5 | |||
Total Cash Flows (I = G+H) | -265000 | -43757.5 | -43757.5 | -43757.5 | -43757.5 | ||
Discount factor @8% (J) 1/(1+8%)^n n=0,1,2,3,4 |
1 | 0.925925926 | 0.85733882 | 0.793832241 | 0.735029853 | ||
Discounted Cash Flows (K = I*J) | -265000 | -40516.2037 | -37515.00343 | -34736.11429 | -32163.06878 | ||
Present value | -409930.3902 | ||||||
r = discount rate = 8% | |||||||
n = 4 years | |||||||
EAC of the System A = [r*PV] / [1 - (1+r)^-n] | |||||||
= [8%*-$409,930.3902] / [1 - (1+8%)^-4] | |||||||
= -$32,794.43122 / 0.264970147 | |||||||
= -$123,766.5132 | |||||||
Calculation of EAC of System B | |||||||
Particulars | 0 | 1 | 2 | 3 | 4 | 5 | 6 |
Initial Investment | |||||||
Cost of system (A) | -345000 | ||||||
Operating Cash Flows | |||||||
Operating costs (B) | -67000 | -67000 | -67000 | -67000 | -67000 | -67000 | |
Depreciation (C ) ($345,000 / 6 years) |
-57500 | -57500 | -57500 | -57500 | -57500 | -57500 | |
Total Expenses (D = B+C) | -124500 | -124500 | -124500 | -124500 | -124500 | -124500 | |
Tax @21% (E = D*21%) | -26145 | -26145 | -26145 | -26145 | -26145 | -26145 | |
Expenses after tax (F = D-E) | -98355 | -98355 | -98355 | -98355 | -98355 | -98355 | |
Add back Depreciation (G = -C) | 57500 | 57500 | 57500 | 57500 | 57500 | 57500 | |
Net Operating Cash Flows (H = F+G) | -40855 | -40855 | -40855 | -40855 | -40855 | -40855 | |
Total Cash Flows (I = G+H) | -345000 | -40855 | -40855 | -40855 | -40855 | -40855 | -40855 |
Discount factor @8% (J) 1/(1+8%)^n n=0,1,2,3,4 |
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