Eads Industrial Systems Company (EISC) is trying to decide between two different

Question

Eads Industrial Systems Company (EISC) is trying to decide between two different conveyor belt systems. System A costs $427,000, has a 6-year life, and requires $115,000 in pretax annual operating costs. System B costs $502,000, has an 8-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 a zero salvage value. Whichever system is chosen, it will not be replaced when it wears out. The tax rate is 33 percent and the discount rate is 24 percent. Which system should the firm choose and why?

A; The net present value is -$588,792.

A; The net present value is -$314,216.

B; The net present value is $308,222.

B: The net present value is -$612,240.

A; The net present value is $211,516.

Explanation / Answer

System A

Initial investment= 427000

Depreciation = (Cost of asset – salvage value)/ life

                                = (427000-0)/6

                                =71,167

Depreciation tax shield = Depreciation x tax rate

                                                = 71,167 x 33%

                                                = 23485

After tax annual operating cost = 115,000 x( 1-0.33)

                                                                = 77,050

Annual cash flow = Depreciation tax shield - After tax annual operating cost

                                   = 23485 – 77,050

                                   = -53,565

NPV = Annual cash flow x PVIFA(6,24%) - Initial investment

        = -53,565 x 3.0205 – 427000

        = -588792

System B

Initial investment= 502000

Depreciation = (Cost of asset – salvage value)/ life

                                = (502000-0)/8

                                =62,750

Depreciation tax shield = Depreciation x tax rate

                                                = 62,750 x 33%

                                                = 20,707.50

After tax annual operating cost = 79000 x( 1-0.33)

                                                                = 52930

Annual cash flow = Depreciation tax shield - After tax annual operating cost

                                   = 20,707.5 – 52930

                                   = -32,222.50

NPV = Annual cash flow x PVIFA(8,24%) - Initial investment

        = -32,222.50 x 3.4212 – 502,000

        = -612240

Project A should be accepted as it has higher NPV.

Hence option A; The net present value is -$588,792 is correct.

Related Questions

Navigate

• Browse (All)
• Browse E
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.