Question

A company has two different devices it can purchase to perform a specific task. Device A costs ?$110,000 ?initially, whereas device B costs ?$150,000. It has been estimated that the cost of maintenance will be ?$5,000 for device A and ?$3,000 for device B in the first year. Management expects these maintenance costs to increase 10?% per year. The company uses a? six-year study? period, and its effective income tax rate is 55?%. Both devices qualify as? five-year MACRS GDS property. Which device should the company choose if the? after-tax, market-based MARR is 8?% per year?

Answer 1

Market based MARR 8%
Increase in Maintenance cost from 2nd year 10%
Device A
Year Initial cost ($) Maintenance cost ($) Tax saving ($) Total Outflow ($) Discount factor at 8% Discounted outflow ($)
0                  (110,000)                  (110,000) 1          (110,000)
1                         (5,000.00)                14,850.00                   9,850.00 0.925925926           9,120.37
2                         (5,500.00)                15,125.00                   9,625.00 0.85733882           8,251.89
3                         (6,050.00)                15,427.50                   9,377.50 0.793832241           7,444.16
4                         (6,655.00)                15,760.25                   9,105.25 0.735029853           6,692.63
5                         (7,320.50)                16,126.28                   8,805.78 0.680583197           5,993.06
6                         (8,052.55)                   4,428.90                 (3,623.65) 0.630169627         (2,283.51)
Total                  (110,000)                       (38,578.05)                81,717.93              (66,860.12)       (74,781.40)
Tax saving on Device A
The depreciation is assumed at straight line method for 5 years
Year Depreciation ($) Maintenance cost ($) Total claimable expenses ($) Tax saving at 55%
1              (22,000.00)                         (5,000.00)              (27,000.00)                 14,850.00
2              (22,000.00)                         (5,500.00)              (27,500.00)                 15,125.00
3              (22,000.00)                         (6,050.00)              (28,050.00)                 15,427.50
4              (22,000.00)                         (6,655.00)              (28,655.00)                 15,760.25
5              (22,000.00)                         (7,320.50)              (29,320.50)                 16,126.28
6                                -                           (8,052.55)                (8,052.55)                   4,428.90
Device B
Year Initial cost ($) Maintenance cost ($) Tax saving ($) Total Outflow ($) Discount factor at 8% Discounted outflow ($)
0                  (150,000)            (150,000.00) 1          (150,000)
1                         (3,000.00)                19,250.00                 16,250.00 0.925925926         15,046.30
2                         (3,300.00)                19,525.00                 16,225.00 0.85733882         13,910.32
3                         (3,630.00)                19,827.50                 16,197.50 0.793832241         12,858.10
4                         (3,993.00)                20,160.25                 16,167.25 0.735029853         11,883.41
5                         (4,392.30)                20,526.28                 16,133.98 0.680583197         10,980.51
6                         (4,831.53)                   4,428.90                    (402.63) 0.630169627             (253.72)
Total                  (150,000)                       (23,146.83)              103,717.93              (69,428.90)       (85,575.08)
Tax saving on Device B
The depreciation is assumed at straight line method for 5 years
Year Initial cost ($) Maintenance cost ($) Total claimable expenses ($) Tax saving at 55%
1              (30,000.00)                         (5,000.00)              (35,000.00)                 19,250.00
2              (30,000.00)                         (5,500.00)              (35,500.00)                 19,525.00
3              (30,000.00)                         (6,050.00)              (36,050.00)                 19,827.50
4              (30,000.00)                         (6,655.00)              (36,655.00)                 20,160.25
5              (30,000.00)                         (7,320.50)              (37,320.50)                 20,526.28
6                                -                           (8,052.55)                (8,052.55)                   4,428.90
Based on above calculation, the net discounted outflow on Device A is $74,781.40, whereas net discounted
outflow on Device B is $85,575.08. Hence, it is advisable to choose Device A