Lang Industrial Systems Company (LISC) is trying to decide between two different

Question

Lang Industrial Systems Company (LISC) is trying to decide between two different conveyor belt systems. System A costs $204,000, has a four-year life, and requires $66,000 in pretax annual operating costs. System B costs $288,000, has a six-year life, and requires $60,000 in pretax annual operating costs. Suppose LISC always needs a conveyor belt system; when one wears out, it must be replaced. Assume the tax rate is 35 percent and the discount rate is 10 percent. Calculate the EAC for both conveyor belt systems. (Negative amounts should be indicated by a minus sign.

Do not round intermediate calculations and round your answers to 2 decimal places. (e.g., 32.16))

Explanation / Answer

If we are trying to decide between two projects that will not be replaced when they wear out, the proper capital budgeting method to use is NPV. Both projects only has costs associated with them, not sales, so we will use these to calculate the NPV of each project. Using the tax shield approach to calculate the OCF, the NPV of system A is:

OCFA = -$66,000(1-0.35) + 0.35($204,000/4)

OCFA= - $25,050

NPVA = - $204,000 - $25,050 (PVIFA10%,4)

NPVA = - $204,000 - $25,050*3.1699

= -283,406

And the NPV of system B is:

OCFB = -$60,000 (1 – 0.35) + 0.35($288,000/6)

OCFB = -$22,200

NPVB = - $288,000 - $22,200(PVIFA10%,6)

NPVB = -$288,000 - $22,200 * 4.3553

= - 384,668

If the system will not be replaced when it wears out, then system A should be chosen, because it has the less negative NPV.

Comparing Mutually Exclusive Projects – Suppose in the previous problem that HISC always needs a conveyor belt system; when one wears out, it must be replaced. Which system should the firm choose now?

If the equipment will be replaced at the end of its useful life, the correct capital budgeting techniques is EAC. Using the NPVs we calculated in the previous problems, the EAC for each system is:

EACA = - $ 283,406 / (PVIFA10%,4)

EACA = -$ 89,405

EACB = -$384668 / (PVIFA10%,6)

EACB = - $88,326

If the conveyor belt system will be continually replaced, we should choose system B since it has the last negative EAC.

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