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 $82,000 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 $210,000 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?

• Aboveground system

• Underground system

Answer 1

For underground automatic irrigation system

Annual Depreciation = $9.2 million/ 20 years = $460000 per year

Annual Tax saving due to depreciation =$460000 * 39% = $179400

Net cashflow annually = $179400 - $82000 =$97400

NPV of project (disregarding revenues) = -9200000 + 97400/0.13*(1-1/1.13^20) = - $8515789.20

So, Equivalent Annual Cost EAC (A) of the project is given by

A/0.13*(1-1/1.13^20) = 8515789.20

=> A = $1212254.85

EAC of the underground system is $1,212,254.85

For Aboveground system

Annual Depreciation = $6.8 million/ 9 years = $755,555.56 per year

Annual Tax saving due to depreciation =$755555.56 * 39% = $294666.67

Net cashflow annually = $294666.67 - $210000 =$84666.67

NPV of project (disregarding revenues) = -6800000 + 84666.67/0.13*(1-1/1.13^9) = - $6365519.87

So, Equivalent Annual Cost EAC (A) of the project is given by

A/0.13*(1-1/1.13^9) = 6365519.87

=> A = $1240441.87

EAC of the aboveground system is $1,240,441.87

We should select Underground system as its Equivalent Annual Cost is lesser than in Above ground system