Question

Letang Industrial Systems Company (LISC) is trying to decide between two different conveyor belt systems. System A costs $280,000, has a four-year life, and requires $85,000 in pretax annual operating costs. System B costs $360,000, has a six-year life, and requires $79,000 in pretax annual operating costs. Suppose the company always needs a conveyor belt system; when one wears out, it must be replaced. Assume the tax rate is 23 percent and the discount rate is 10 percent. calculate the EAC for both conveyor belt systems to 2 decimal places and a negative answer should be indicated by a minus sign

Answer 1

System A

Time line		0	1	2	3	4
Cost of new machine		-280000
=Initial Investment outlay		-280000
Sales			0	0	0	0
Profits	Sales-variable cost		0	0	0	0
Operating cost			-85000	-85000	-85000	-85000
-Depreciation	Cost of equipment/no. of years		-70000	-70000	-70000	-70000
=Pretax cash flows			-155000	-155000	-155000	-155000
-taxes	=(Pretax cash flows)*(1-tax)		-119350	-119350	-119350	-119350
+Depreciation			70000	70000	70000	70000
=after tax operating cash flow			-49350	-49350	-49350	-49350
+Tax shield on salvage book value	=Salvage value * tax rate					0
=Terminal year after tax cash flows						0
Total Cash flow for the period		-280000	-49350	-49350	-49350	-49350
Discount factor=	(1+discount rate)^corresponding period	1	1.1	1.21	1.331	1.4641
Discounted CF=	Cashflow/discount factor	-280000	-44863.64	-40785.124	-37077.39	-33706.71
NPV=	Sum of discounted CF=	-436432.8598

EAC	-137681.825
Year or period		0	1	2	3	4
EAC			-137681.8	-137681.83	-137681.8	-137681.8
Discount factor=	(1+discount rate)^corresponding period		1.1	1.21	1.331	1.4641
Discounted CF=	Cashflow/discount factor		-125165.3	-113786.63	-103442.4	-94038.54
NPV=	-436432.8598
EAC is equivalent yearly CF with same NPV =	-137681.83

System B

Time line		0	1	2	3	4	5	6
Cost of new machine		-360000
=Initial Investment outlay		-360000
Sales			0	0	0	0	0	0
Profits	Sales-variable cost		0	0	0	0	0	0
Operating cost			-79000	-79000	-79000	-79000	-79000	-79000
-Depreciation	Cost of equipment/no. of years		-60000	-60000	-60000	-60000	-60000	-60000
=Pretax cash flows			-139000	-139000	-139000	-139000	-139000	-139000
-taxes	=(Pretax cash flows)*(1-tax)		-107030	-107030	-107030	-107030	-107030	-107030
+Depreciation			60000	60000	60000	60000	60000	60000
=after tax operating cash flow			-47030	-47030	-47030	-47030	-47030	-47030
+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	-47030	-47030	-47030	-47030	-47030	-47030
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	-42754.55	-38867.769	-35334.34	-32122.12	-29201.93	-26547.21
NPV=	Sum of discounted CF=	-564827.9107

EAC	-129688.6569
Year or period		0	1	2	3	4	5	6
EAC			-129688.7	-129688.66	-129688.7	-129688.7	-129688.7	-129688.7
Discount factor=	(1+discount rate)^corresponding period		1.1	1.21	1.331	1.4641	1.61051	1.771561
Discounted CF=	Cashflow/discount factor		-117898.8	-107180.71	-97437.01	-88579.1	-80526.45	-73205.87
NPV=	-564827.9107
EAC is equivalent yearly CF with same NPV =	-129688.66