Vandalay Industries is considering the purchase of a new machine for the product
ID: 2718673 • Letter: V
Question
Vandalay Industries is considering the purchase of a new machine for the production of latex. Machine A costs $2,200,000 and will last for 7 years. Variable costs are 36 percent of sales, and fixed costs are $132,000 per year. Machine B costs $4,390,000 and will last for 10 years. Variable costs for this machine are 28 percent of sales and fixed costs are $83,000 per year. The sales for each machine will be $8.78 million per year. The required return is 10 percent and the tax rate is 35 percent. Both machines will be depreciated on a straight-line basis. Required: (a) If the company plans to replace the machine when it wears out on a perpetual basis, what is the EAC for machine A? (Do not round your intermediate calculations.) (b) If the company plans to replace the machine when it wears out on a perpetual basis, what is the EAC for machine B
Explanation / Answer
Machine A
NPV = - Initial Investment - Annual Cash OutFlow *PVIFA(rate,nper)
Annual Depreciation = 2200000/7
Annual Cash Flow = (Sale Revenue *Variable costs%+fixed costs )*(1-tax rate) - Annual Depreciation * tax rate
Annual Cash Flow = (8780000*36%+ 132000)*(1-35%) - 2200000/7*35%
Annual Cash Flow = $ 2,030,320
NPV = -2200000 -2030320*PVIFA(10%,7)
NPV =-2200000 -2030320*4.868419
NPV = $ - 12,084,448.46
EAC for Machine A = NPV/PVIFA(10%,7)
EAC for Machine A = - 12,084,448.46/4.868419
EAC for Machine A = - $ 2,482,212.08
Machine B
NPV = - Initial Investment + Annual Cash OutFlow *PVIFA(rate,nper)
Annual Depreciation = 4390000/10 = 439000
Annual Cash Flow = (Sale Revenue *Variable costs%+ fixed costs )*(1-tax rate) + Annual Depreciation * tax rate
Annual Cash Flow = (8780000*28%+36000)*(1-35%) - 439000*35%
Annual Cash Flow = $ 1,467,710
NPV = -4390000 - 1467710*PVIFA(10%,10)
NPV = -4390000 - 1467710*6.144567
NPV = $ - 13408442.43
EAC for Machine B = NPV/PVIFA(10%,10)
EAC for Machine B = - 13408442.43/6.144567
EAC for Machine B = - $ 2,182,162.30
Note :
Decision: Select Machine B as its EAC is lower than Machine A
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