Question

Letang Industrial Systems Company (LISC) is trying to decide between two different conveyor belt systems. System A costs $265,000, has a four-year life, and requires $73,000 in pretax annual operating costs. System B costs $345,000, has a six-year life, and requires $67,000 in pretax annual operating costs. The company always needs a conveyor belt system; when one wears out, it must be replaced. Assume the tax rate is 21 percent and the discount rate is 8 percent.

Calculate the EAC 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.)

Answer 1

Depreciation method not provided, assuming straight line

System A

Time line		0	1	2	3	4
Cost of new machine		-265000
=Initial Investment outlay		-265000
Operating cost			-73000	-73000	-73000	-73000
-Depreciation	Cost of equipment/no. of years		-66250	-66250	-66250	-66250
=Pretax cash flows			-139250	-139250	-139250	-139250
-taxes	=(Pretax cash flows)*(1-tax)		-110007.5	-110007.5	-110007.5	-110007.5
+Depreciation			66250	66250	66250	66250
=after tax operating cash flow			-43757.5	-43757.5	-43757.5	-43757.5
+Tax shield on salvage book value	=Salvage value * tax rate					0
=Terminal year after tax cash flows						0
Total Cash flow for the period		-265000	-43757.5	-43757.5	-43757.5	-43757.5
Discount factor=	(1+discount rate)^corresponding period	1	1.08	1.1664	1.259712	1.360489
Discounted CF=	Cashflow/discount factor	-265000	-40516.2	-37515.003	-34736.11	-32163.07
NPV=	Sum of discounted CF=	-409930.39

Year or period		0	1	2	3	4
EAC			-123766.5	-123766.51	-123766.5	-123766.5
Discount factor=	(1+discount rate)^corresponding period		1.08	1.1664	1.259712	1.360489
Discounted CF=	Cashflow/discount factor		-114598.6	-106109.84	-98249.85	-90972.08
NPV=	-409930.3902
EAC is equivalent yearly CF with same NPV =	-123766.5132

System B

Time line		0	1	2	3	4	5	6
Cost of new machine		-345000
=Initial Investment outlay		-345000
Operating cost			-67000	-67000	-67000	-67000	-67000	-67000
-Depreciation	Cost of equipment/no. of years		-57500	-57500	-57500	-57500	-57500	-57500
=Pretax cash flows			-124500	-124500	-124500	-124500	-124500	-124500
-taxes	=(Pretax cash flows)*(1-tax)		-98355	-98355	-98355	-98355	-98355	-98355
+Depreciation			57500	57500	57500	57500	57500	57500
=after tax operating cash flow			-40855	-40855	-40855	-40855	-40855	-40855
+Tax shield on salvage book value	=Salvage value * tax rate							0
=Terminal year after tax cash flows								0
Total Cash flow for the period		-345000	-40855	-40855	-40855	-40855	-40855	-40855
Discount factor=	(1+discount rate)^corresponding period	1	1.08	1.1664	1.259712	1.360489	1.4693281	1.5868743
Discounted CF=	Cashflow/discount factor	-345000	-37828.7	-35026.578	-32432.02	-30029.64	-27805.23	-25745.58
NPV=	Sum of discounted CF=	-533867.75

Year or period		0	1	2	3	4	5	6
EAC			-115483.8	-115483.81	-115483.8	-115483.8	-115483.8	-115483.8
Discount factor=	(1+discount rate)^corresponding period		1.08	1.1664	1.259712	1.360489	1.4693281	1.5868743
Discounted CF=	Cashflow/discount factor		-106929.5	-99008.752	-91674.77	-84884.05	-78596.34	-72774.39
NPV=	-533867.7487
EAC is equivalent yearly CF with same NPV =	-115483.8082