Question

The Tempo Golf and Country Club in London, Ontario, is evaluating two different irrigation system options. An underground automatic irrigation system will cost $9.2 million to install and $81,200 pre-tax annually to operate. It will not have to be replaced for 20 years. An aboveground system will cost $6.8 million to install, but $202,000 per year to operate. The aboveground equipment has an effective operating life of nine years. The country club leases its land from the city and both systems are considered leasehold improvements; as a result, straight-line capital cost allowance is used throughout, and neither system has any salvage value. The tax rate is 39%.

Calculate the equivalent annual cost for each method if we use a 13% discount rate? (Enter the answers in dollars. Do not round your intermediate calculations. Round the final answers to 2 decimal places. Negative answers should be indicated by a minus sign. Omit $ sign in your response.)

Method	EAC
Underground system	$
Aboveground system	$

Which method should we select?

• Underground system

• Aboveground system

Answer 1

Equivalent annual cost (EAC) = (NPV * r) / (1 - (1 + r)^-n)

where NPV = net present value

r = discount rate

n = life of system in years

NPV = sum of present values of cash flows

present value = future value / (1 + r)^{number of years}

cash outflow in year 0 = installation cost of system

cash outflow in subsequent years = (pretax operating cost * (1 - tax rate)) - (depreciation * tax rate)

depreciation in each year = cost of system / life in years

The above ground system should be selected as the EAC is lower