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. 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 23 percent and the discount rate is 10 percent.

Answer 1

We have to calculate the EAC for both the conveyor belt system.

Solutions :

Equivalent Annual Cost or (EAC) for the SYSTEM-A

$\text{Operating cash flow } = \text{Pre-tax annual operating cost (1-tax rate )} + (\text{depreciation expense} \times$tax rate )

                                $=-855,000(1-0.23)+\left[\left(\frac{280,000}{4}\right)\times 0.23\right]$

                               $= (-85,000 \times 0.77 ) + (70,000 \times 0.23)$

                               = $ 49,350

Year      Annual Cost flow     Present value factor    Present Value of Annual

                                                     at 10%                              cash flow

1                    -49,350                  0.909091                          -44,863.64

2                  -49,350                   0.826446                          -40,785.12

3                   -49,350                  0.751315                            -37,077.39

4                   -49,350                 0.683013                         -33,706.71  

     Total                                    $ 3.169865                       $ -156,432.86  

Therefore, Net Present value = present value of the annual cash flow - initial investment.

           = 156,432.86 - 280,000

          = $ 436,432.86 (negative)

Now the EAC or the Equivalent Annual Cost for System A :

$\text{EAC}= \text{Net present value / (PVIFA 10 percent, 4 years)}$

        $=\frac{436,432.86}{3.169865}$

        $= 137,681.86$ dollar (negative)

$\text{Operating cash flow } = \text{Pre-tax annual operating cost (1-tax rate )} + (\text{depreciation expense} \times$tax rate)

$=79,000(1-0.23)+\left[\left(\frac{360,000}{6}\right) \times 0.23\right]$

$=(-78,000 \times 0.77)+(60,000 \times 0.23)$

= -$ 47,030

Year      Annual Cost flow     Present value factor    Present Value of Annual

                                                     at 10%                              cash flow

1                    -47,030                  0.909091                          -42,754.55

2                  -47,030                   0.826446                          -38,867.77

3                   -47,030                  0.751315                           -35,334.34

4                   -47,030                 0.683013                            -32,122.12

5                  -47,030                  0.620921                            -29,201.93

6                  -47,030                 0.564474                            -26,547.21  

    Total                                     $ 4.355261                       $  -204,827.91

Net Present Value = Present Value of annual cash inflows – Initial Investment

$= 204,827.91 - 360,000$

= -$ 564,827.91 (negative)

EAC for system B:

Equivalent Annual Cost for system B $=\frac{\text{net present value}}{\text{PVIFA 10 \text percent, 6 years}}$

$=\frac{-564,827.91}{4.355261}$

= -$129,688.66 (negative)