Question

Lang Industrial Systems Company (LISC) is trying to decide between two different conveyor belt systems. System A costs $256,000, has a four-year life, and requires $79,000 in pretax annual operating costs. System B costs $360,000, has a six-year life, and requires $73,000 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 35 percent and the discount rate is 10 percent. NPV System A $ System B $ 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		-256000
=Initial Investment outlay		-256000
Annual operating costs			-79000	-79000	-79000	-79000
-Depreciation	Cost of equipment/no. of years		-64000	-64000	-64000	-64000
=Pretax cash flows			-143000	-143000	-143000	-143000
-taxes	=(Pretax cash flows)*(1-tax)		-92950	-92950	-92950	-92950
+Depreciation			64000	64000	64000	64000
=after tax operating cash flow			-28950	-28950	-28950	-28950
+Tax shield on salvage book value	=Salvage value * tax rate					0
=Terminal year after tax cash flows						0
Total Cash flow for the period		-256000	-28950	-28950	-28950	-28950
Discount factor=	(1+discount rate)^corresponding period	1	1.1	1.21	1.331	1.4641
Discounted CF=	Cashflow/discount factor	-256000	-26318.18	-23925.62	-21750.56	-19773.24
NPV=	Sum of discounted CF=	-347767.6

System B

Time line		0	1	2	3	4	5	6
Cost of new machine		-360000
=Initial Investment outlay		-360000
Profits			-73000	-73000	-73000	-73000	-73000	-73000
-Depreciation	Cost of equipment/no. of years		-60000	-60000	-60000	-60000	-60000	-60000
=Pretax cash flows			-133000	-133000	-133000	-133000	-133000	-133000
-taxes	=(Pretax cash flows)*(1-tax)		-86450	-86450	-86450	-86450	-86450	-86450
+Depreciation			60000	60000	60000	60000	60000	60000
=after tax operating cash flow			-26450	-26450	-26450	-26450	-26450	-26450
+Tax shield on salvage book value	=Salvage value * tax rate							0
=Terminal year after tax cash flows								0
Total Cash flow for the period		-360000	-26450	-26450	-26450	-26450	-26450	-26450
Discount factor=	(1+discount rate)^corresponding period	1	1.1	1.21	1.331	1.4641	1.61051	1.771561
Discounted CF=	Cashflow/discount factor	-360000	-24045.45	-21859.504	-19872.28	-18065.71	-16423.4	-14930.34
NPV=	Sum of discounted CF=	-475196.65

Choose system A as it has higher NPV