Your company is evaluating two different water purification systems for its main
ID: 2648368 • Letter: Y
Question
Your company is evaluating two different water purification systems for its main factory: Option X will cost $3.00 million and $500,000 annually to operate, and has a life of five years. Option Y will cost $4.80 million and $20,000 per year to operate, and has a life of six years. Straight-line depreciation is to be used, and both systems will be depreciated fully over their respective lives. The systems will have no salvage values at the end of their respective lives. Suppose your company is very profitable, has a discount rate of 10%, and the corporate tax rate is 40%. Which filtration system should your company buy?
Explanation / Answer
Option X
Annual Depreciation = 3000000/5 = 600000
Annual Operating Cost after tax = (500000 *(1-40%) - 600000*40%)
Annual Operating Cost after tax = $ 60,000
Present Value of Total Cost = 3000000 + 60000*PVIFA(10%,5)
Present Value of Total Cost = 3000000 + 60000*3.79079
Present Value of Total Cost = 3,227,447.40
Effective Annual Cash Cost = Present Value of Total Cost / PVIFA(10%,5)
Effective Annual Cash Cost = 3227447.40/3.79079
Effective Annual Cash Cost = $ 851,391.77
Option Y
Annual Depreciation = 4800000/6 = 800000
Annual Operating Cost after tax = (20000 *(1-40%) - 800000*40%)
Annual Operating Cost after tax = $ -308,000
Present Value of Total Cost = 4800000 -308000*PVIFA(10%,5)
Present Value of Total Cost = 4800000 - 308000 * 4.35526
Present Value of Total Cost = 3,458,579.92
Effective Annual Cash Cost = Present Value of Total Cost / PVIFA(10%,6)
Effective Annual Cash Cost = 3458579.92/4.35526
Effective Annual Cash Cost = $ 794,115.60
Decision : Option Y filtration system should your company buy as its Effective Annual Cash Cost is Lower than Option X
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