Question

Hagar Industrial Systems Company (HISC) is trying to decide between two different conveyor belt systems. System A costs $315,000, has a 4-year life, and requires $113,000 in pretax annual operating costs. System B costs $395,000, has a 6-year life, and requires $107,000 in pretax annual operating costs. Suppose the company always needs a conveyor belt system; when one wears out, it must be replaced. Assume the tax rate is 25 percent and the discount rate is 9 percent.

Calculate the EAC for both conveyor belt systems. (A negative answer should be indicated by a minus sign. Do not round intermediate calculations and round your answers to 2 decimal places, e.g., 32.16.)

Which conveyor belt system should the firm choose?

System B System A

Answer 1

System A

Time line		0	1	2	3	4
Cost of new machine		-315000
=Initial Investment outlay		-315000
							100.00%
Sales			0	0	0	0
Profits	Sales-variable cost		0	0	0	0
Operating cost			-113000	-113000	-113000	-113000
-Depreciation	Cost of equipment/no. of years		-78750	-78750	-78750	-78750	0	=Salvage Value
=Pretax cash flows			-191750	-191750	-191750	-191750
-taxes	=(Pretax cash flows)*(1-tax)		-143812.5	-143812.5	-143812.5	-143812.5
+Depreciation			78750	78750	78750	78750
=after tax operating cash flow			-65062.5	-65062.5	-65062.5	-65062.5
+Tax shield on salvage book value	=Salvage value * tax rate					0
=Terminal year after tax cash flows						0
Total Cash flow for the period		-315000	-65062.5	-65062.5	-65062.5	-65062.5
Discount factor=	(1+discount rate)^corresponding period	1	1.09	1.1881	1.295029	1.4115816
Discounted CF=	Cashflow/discount factor	-315000	-59690.367	-54761.8046	-50240.1877	-46091.92
NPV=	Sum of discounted CF=	-525784.27

Year or period		0	1	2	3	4
EAC			-162293.127	-162293.127	-162293.127	-162293.1
Discount factor=	(1+discount rate)^corresponding period		1.09	1.1881	1.295029	1.4115816
Discounted CF=	Cashflow/discount factor		-148892.777	-136598.878	-125320.072	-114972.5
NPV=	-525784.27
EAC is equivalent yearly CF with same NPV =	-162293.13

System B

Time line		0	1	2	3	4	5	6
Cost of new machine		-395000
=Initial Investment outlay		-395000
									100.00%
Sales			0	0	0	0	0	0
Profits	Sales-variable cost		0	0	0	0	0	0
Operating cost			-107000	-107000	-107000	-107000	-107000	-107000
-Depreciation	Cost of equipment/no. of years		-65833.3333	-65833.3333	-65833.3333	-65833.33	-65833.33	-65833.33	5.82077E-11	=Salvage Value
=Pretax cash flows			-172833.333	-172833.333	-172833.333	-172833.3	-172833.3	-172833.3
-taxes	=(Pretax cash flows)*(1-tax)		-129625	-129625	-129625	-129625	-129625	-129625
+Depreciation			65833.33333	65833.33333	65833.33333	65833.333	65833.333	65833.333
=after tax operating cash flow			-63791.67	-63791.67	-63791.67	-63791.67	-63791.67	-63791.67
+Tax shield on salvage book value	=Salvage value * tax rate							1.455E-11
=Terminal year after tax cash flows								0
Total Cash flow for the period		-395000	-63791.67	-63791.67	-63791.67	-63791.67	-63791.67	-63791.67
Discount factor=	(1+discount rate)^corresponding period	1	1.09	1.1881	1.295029	1.4115816	1.538624	1.6771001
Discounted CF=	Cashflow/discount factor	-395000	-58524.4679	-53692.1724	-49258.8737	-45191.63	-41460.21	-38036.89
NPV=	Sum of discounted CF=	-681164.24

Year or period		0	1	2	3	4	5	6
EAC			-151844.985	-151844.985	-151844.985	-151845	-151845	-151845
Discount factor=	(1+discount rate)^corresponding period		1.09	1.1881	1.295029	1.4115816	1.538624	1.6771001
Discounted CF=	Cashflow/discount factor		-139307.325	-127804.886	-117252.189	-107570.8	-98688.82	-90540.2
NPV=	-681164.24
EAC is equivalent yearly CF with same NPV =	-151844.98

Choose System B as it has smaller EAC