You are evaluating two different unobtenium processing machines. The Avatar I co

Question

You are evaluating two different unobtenium processing machines. The Avatar I costs $197,000, has a 2-year life, and has pretax operating costs of $39,000 per year. The Avatar II costs $291,000, has a 5-year life, and has pretax operating costs of $21,000 per year. For both 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 33 percent and your discount rate is 10 percent. The Avatar I has an EAC of $ , while the Avatar II has an EAC of $ . You prefer Avatar

Explanation / Answer

We will need the aftertax salvage value of the equipment to compute the EAC. Even though the equipment for each product has a different initial cost, both have the same salvage value. The aftertax salvage value for both is:

Both cases: aftertax salvage value = $20,000(1 – 0.33) = $13,400

To calculate the EAC, we first need the OCF and NPV of each option. The OCF and NPV for Avatar I is:

OCF = –$39,000(1 – 0.33) + 0.33($197,000/2) = 6,375.00

NPV = –$197,000 + $6,375.00(PVIFA10%,2) + ($13,400/1.102) = –$174,861.58

EAC = –$174,861.58 / (PVIFA10%,2) = –$100,753.57

And the OCF and NPV for Avatar II is:

OCF = –$21,000(1 – 0.33) + 0.33($291,000/5) = $5,136

NPV = –$291,000 + $5,136(PVIFA10%,5) + ($13,400/1.105) = –$263,210.17

EAC = –$263,210.17 / (PVIFA10%,5) = –$69,435.76

The two machines have unequal lives, so they can only be compared by expressing both on an equivalent annual basis, which is what the EAC method does. Thus, you prefer the Avatar II because it has the lower (less negative) annual cost.

Note: PVIFA is Present value of annuity factor using rate and number of periods, NPV is Net present value and OCF is operating cash flow.

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