Calculating EAC You are evaluating two different silicon wafer milling machines.

Question

Calculating EAC You are evaluating two different silicon wafer milling machines. The Techron I costs $245,000, has a three-year life, and has pretax operating costs (i.e., variable costs and fixed costs) of $39,000 per year. The Techron II costs $315,000, has a five-year life, and has pretax operating costs of $48,000 per year. For both milling machines, use straight-line depreciation to zero over the project's life and assume a salvage value of $20,000. If your tax rate is 35 percent and your discount rate is 9 percent, compute the EAC for both machines. Which do you prefer? Why? 6. Hint]: For each option, 1) you need to construct a time table with after-tax cash flow information as you do for NPV analysis in questions #243; 2) Get total cash flow information every year, 3) EAC-EAA (equivalent annual annuity (i.e., PMT) that we covered in class last week); 4) if your NPV is a negative number, it would mean your EAA is a negative number, it's a cost to you. Which option would you choose if you need to pick one?

Explanation / Answer

Solution: EAC Techron I -89,589.37 Techron II -87,961.95 Machine Techron II to be chosen is as EAC is lower in case of Techron II Techron II Working Notes: Techron I After tax salvage value = $20,000(1 0.35) = $13,000 Operating cash flow = operating cost net of tax + tax saving on depreciation = -39,000(1-0.35) + (245,000/3)x 35% =-25,350 + 28,583.33333 =3,233.33333 NPV = $245,000 + ($3,233.33333 x Cumulative PVF @ 9% 1 to 3 years) + ($13,000/(1.09)^3) = -$245,000 + (3,233.33333 X 2.5312946 ) + 13,000/1.295029 = -245,000+8,184.519198 + 10,038.3852 =-226,777.0956 EAC = 226,777.0956 / Cumulative PVF @ 9% 1 to 3 years EAC= -226,777.0956/2.5312946 EAC= -89,589.37 Techron II After tax salvage value = $20,000(1 0.35) = $13,000 Operating cash flow = operating cost net of tax + tax saving on depreciation = -48,000(1-0.35) + (315,000/5)x 35% =-31,200 + 22,050 =-9,150 NPV = $315,000 -9,150 x Cumulative PVF @ 9% 1 to 5 years) + ($13,000/(1.09)^5) = -$315,000 -(9,150 X 3.88965) + 13,000/1.53862395 =-342,141.18945 EAC = 342,141.18945/ Cumulative PVF @ 9% 1 to 5 years EAC= 342,141.18945/3.88965 EAC= -87,961.94759 EAC=-87,961.95 Notes: Cumulative PVF @ 9 % for ( 1 to 3 years) for Techron I is calculated = (1 - (1/(1 + 0.09)^3) ) /0.09 =2.53129467 Cumulative PVF @ 9 % for ( 1 to 5 years) for Techron II is calculated = (1 - (1/(1 + 0.09)^5) ) /0.09 =3.88965 . Please feel free to ask if anything about above solution in comment section of the question.

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