Question

Letang Industrial Systems Company (LISC) is trying to decide between two different conveyor belt systems. System A costs $285,000, has a four-year life, and requires $89,000 in pretax annual operating costs. System B costs $365,000, has a six-year life, and requires $83,000 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. The tax rate is 24 percent and the discount rate is 11 percent.

Calculate the NPV for both conveyor belt systems. (A negative answer should be indicated by a minus sign. Do not round intermediate calculations and round your answers to 2 decimal places, e.g., 32.16.)

Which conveyor belt system should the firm choose?

System B System A

Answer 1

System A

Time line		0	1	2	3	4
Cost of new machine		-285000
=Initial Investment outlay		-285000
Sales			0	0	0	0
Profits	Sales-variable cost		0	0	0	0
Operating cost			-89000	-89000	-89000	-89000
-Depreciation	Cost of equipment/no. of years		-71250	-71250	-71250	-71250
=Pretax cash flows			-160250	-160250	-160250	-160250
-taxes	=(Pretax cash flows)*(1-tax)		-121790	-121790	-121790	-121790
+Depreciation			71250	71250	71250	71250
=after tax operating cash flow			-50540	-50540	-50540	-50540
+Tax shield on salvage book value	=Salvage value * tax rate					0
=Terminal year after tax cash flows						0
Total Cash flow for the period		-285000	-50540	-50540	-50540	-50540
Discount factor=	(1+discount rate)^corresponding period	1	1.11	1.2321	1.367631	1.5180704
Discounted CF=	Cashflow/discount factor	-285000	-45531.53	-41019.398	-36954.41	-33292.26
NPV=	Sum of discounted CF=	-441797.61

System B

Time line		0	1	2	3	4	5	6
Cost of new machine		-365000
=Initial Investment outlay		-365000
Sales			0	0	0	0	0	0
Profits	Sales-variable cost		0	0	0	0	0	0
Operating cost			-83000	-83000	-83000	-83000	-83000	-83000
-Depreciation	Cost of equipment/no. of years		-60833.33	-60833.333	-60833.33	-60833.33	-60833.33	-60833.33
=Pretax cash flows			-143833.3	-143833.33	-143833.3	-143833.3	-143833.3	-143833.3
-taxes	=(Pretax cash flows)*(1-tax)		-109313.3	-109313.33	-109313.3	-109313.3	-109313.3	-109313.3
+Depreciation			60833.333	60833.3333	60833.333	60833.333	60833.333	60833.333
=after tax operating cash flow			-48480	-48480	-48480	-48480	-48480	-48480
+Tax shield on salvage book value	=Salvage value * tax rate							0
=Terminal year after tax cash flows								0
Total Cash flow for the period		-365000	-48480	-48480	-48480	-48480	-48480	-48480
Discount factor=	(1+discount rate)^corresponding period	1	1.11	1.2321	1.367631	1.5180704	1.6850582	1.8704146
Discounted CF=	Cashflow/discount factor	-365000	-43675.68	-39347.456	-35448.16	-31935.28	-28770.52	-25919.39
NPV=	Sum of discounted CF=	-570096.48

Choose project A as it has smaller negative NPV