5. Equivalent annual cost. A Nice Company is trying to decide between two differ

Question

5. Equivalent annual cost. A Nice Company is trying to decide between two different electronic production quality control systems (X and Y). System X has an initial outlay of $360,000, has a four year life, and requires S105,000 in pretax annual operating cost. System Y costs $480,000 today but has a six year life, and requires S65,000 in pretax annual operating cash costs. Both systems are to be depreciated straight line to zero book value over their lives but both systems are estimated to have a market value which is 15% of the purchase price. Whichever system is chosen, it is likely that it will be replaced if it wears out, with the same system (hence you can base your decision on equivalent annual cost) If the tax rate is 34 percent and the discount rate is 12 percent, which system should the firm choose?

Explanation / Answer

System X: Annual operating costs net of tax = 105000*0.66 = $        69,300 Annual depreciation tax shield = (360000/4)*0.34 = $        30,600 Salvage value net of tax = 360000*15%*66% = $        35,640 Annualized net salvage value = 35640*0.12*1.12^4/(1.12^4-1) = $        11,734 Equivalent annual cost = 69300-30600-11734 = $        26,966 System Y: Annual operating costs net of tax = 65000*0.66 = $        42,900 Annual depreciation tax shield = (480000/6)*0.34 = $        27,200 Salvage value net of tax = 480000*15%*66% = $        47,520 Annualized net salvage value = 47520*0.12*1.12^6/(1.12^6-1) = $        11,558 Equivalent annual cost = 42900-27200-11558 = $          4,142 DECISION: As System Y has lower EAC, it should be chosen.

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