Question

EDP is trying to decide between two different conveyor belt systems. System A costs $438,000, has a six-year life, and requires $83,000 in pretax annual operating costs. System B costs $369,000, has a five-year life, and requires $92,000 in pretax annual operating costs. Both systems are to be depreciated straight-line to zero over their lives and will have a zero salvage value. Whichever system is chosen, it will not be replaced when it wears out. The tax rate is 23 percent and the discount rate is 14.2 percent. Which system should the firm choose and why?

Answer 1

System A

Time line		0	1	2	3	4	5	6
Cost of new machine		-438000
=Initial Investment outlay		-438000
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		-73000	-73000	-73000	-73000	-73000	-73000
=Pretax cash flows			-156000	-156000	-156000	-156000	-156000	-156000
-taxes	=(Pretax cash flows)*(1-tax)		-120120	-120120	-120120	-120120	-120120	-120120
+Depreciation			73000	73000	73000	73000	73000	73000
=after tax operating cash flow			-47120	-47120	-47120	-47120	-47120	-47120
+Tax shield on salvage book value	=Salvage value * tax rate							0
=Terminal year after tax cash flows								0
Total Cash flow for the period		-438000	-47120	-47120	-47120	-47120	-47120	-47120
Discount factor=	(1+discount rate)^corresponding period	1	1.142	1.304164	1.4893553	1.7008437	1.9423635	2.2181792
Discounted CF=	Cashflow/discount factor	-438000	-41260.95	-36130.425	-31637.85	-27703.9	-24259.1	-21242.65
NPV=	Sum of discounted CF=	-620234.8713

System B

Time line		0	1	2	3	4	5
Cost of new machine		-369000
=Initial Investment outlay		-369000
Sales			0	0	0	0	0
Profits	Sales-variable cost		0	0	0	0	0
Operating cost			-92000	-92000	-92000	-92000	-92000
-Depreciation	Cost of equipment/no. of years		-73800	-73800	-73800	-73800	-73800
=Pretax cash flows			-165800	-165800	-165800	-165800	-165800
-taxes	=(Pretax cash flows)*(1-tax)		-127666	-127666	-127666	-127666	-127666
+Depreciation			73800	73800	73800	73800	73800
=after tax operating cash flow			-53866	-53866	-53866	-53866	-53866
+Tax shield on salvage book value	=Salvage value * tax rate						0
=Terminal year after tax cash flows							0
Total Cash flow for the period		-369000	-53866	-53866	-53866	-53866	-53866
Discount factor=	(1+discount rate)^corresponding period	1	1.142	1.304164	1.4893553	1.7008437	1.9423635
Discounted CF=	Cashflow/discount factor	-369000	-47168.13	-41303.088	-36167.33	-31670.16	-27732.19
NPV=	Sum of discounted CF=	-553040.8974

Choose System B as it has higher NPV