Question

Vandalay Industries is considering the purchase of a new machine for the production of latex. Machine A costs $2,290,000 and will last for 8 years. Variable costs are 39 percent of sales, and fixed costs are $134,000 per year. Machine B costs $4,590,000 and will last for 10 years. Variable costs for this machine are 29 percent of sales and fixed costs are $128,000 per year. The sales for each machine will be $9.18 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. Required: (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? (Do not round your intermediate calculations.)

Answer 1

Machine A:

Cost of Machine = $2,290,000
Useful Life = 8 years

Annual Depreciation = Cost of Machine / Useful Life
Annual Depreciation = $2,290,000 / 8
Annual Depreciation = $286,250

Variable Costs = 39% * Sales
Variable Costs = 39% * $9,180,000
Variable Costs = $3,580,200

Pretax Operating Costs = Variable Costs + Fixed Costs
Pretax Operating Costs = $3,580,200 + $134,000
Pretax Operating Costs = $3,714,200

Annual OCF = Pretax Operating Costs * (1 - tax) + tax * Depreciation
Annual OCF = -$3,714,200 * (1 - 0.35) + 0.35 * $286,250
Annual OCF = -$2,314,042.50

NPV = -$2,290,000 - $2,314,042.50 * PVIFA(10%, 8)
NPV = -$2,290,000 - $2,314,042.50 * 5.33493
NPV = -$14,635,254.7545

EAC = NPV / PVIFA(10%, 8)
EAC = -$14,635,254.7545 / 5.33493
EAC = -$2,743,288.99

Machine B:

Cost of Machine = $4,590,000
Useful Life = 10 years

Annual Depreciation = Cost of Machine / Useful Life
Annual Depreciation = $4,590,000 / 10
Annual Depreciation = $459,000

Variable Costs = 29% * Sales
Variable Costs = 29% * $9,180,000
Variable Costs = $2,662,200

Pretax Operating Costs = Variable Costs + Fixed Costs
Pretax Operating Costs = $2,662,200 + $128,000
Pretax Operating Costs = $2,790,200

Annual OCF = Pretax Operating Costs * (1 - tax) + tax * Depreciation
Annual OCF = -$2,790,200 * (1 - 0.35) + 0.35 * $459,000
Annual OCF = -$1,652,980

NPV = -$4,590,000 - $1,652,980 * PVIFA(10%, 10)
NPV = -$4,590,000 - $1,652,980 * 6.14457
NPV = -$14,746,851.3186

EAC = NPV / PVIFA(10%, 10)
EAC = -$14,746,851.3186 / 6.14457
EAC = -$2,399,981.01