Question

Blooper Industries must replace its magnoosium purification system. Quick & Dirty Systems sells a relatively cheap purification system for $15 million. The system will last 5 years. Do-It-Right sells a sturdier but more expensive system for $21 million; it will last for 7 years. Both systems entail $2 million in operating costs; both will be depreciated straight-line to a final value of zero over their useful lives: neither will have any salvage value at the end of its life. The firm's tax rate is 30%, and the discount rate is 12%. Either machine will be replaced at the end of its life. a. What is the equivalent annual cost of investing in the cheap system? (Do not round intermediate calculations. Enter your answer as a positive value. Enter your answer in millions rounded to 2 decimal places.) b. What is the equivalent annual cost of investing in the more expensive system? (Do not round intermediate calculations. Enter your answer as a positive value. Enter your answer in millions rounded to 2 decimal places.) c. Which system should Blooper install? millions Equivalent annual cost Equivalent annual cost Which system should Blooper install? millions c. Quick & Dirty

Answer 1

DATA GIVEN particulars expensive system cheap system in millions dollars in millions dollars 15 21 cost operating cost use full life of asset 2 2 5 straight line method straight line method method of depreciation depreciation tax rate discount rate 30% 30% 12% A CHEAP SYSTEM Year cash out flow operating cost 151 depreclaiton 0 21 0 1 present value of net cash OUT flows net cash OUT amount in total tax @ 30% flows after tax pvf@12% millions) 151 3.5| 0.8929 3.1250 0.79721 2.7902 3.5 0.71181 2.4912 3.5 0.63551 2.2243 3.51 0.5674 1.9860 15 2 3.5 27.6167 total numbers of years equivalent annual cost of investing 5.52

B EXPENSIVE SYSTEM present value of net cash OUT flows (amount in millions ) net cash OUT depreciaiton total tax @ 30 % flows after tax cash out flow pvf@12% operating cost 21 21 3.5 3.125 2.7902 1.5 3.5 3.5 2.4912 3.5 0.8929 0.7972) 0.7118 0.63551 0.5674 0.5066 0.45231 5 21 1.5 3.51 3.5 3.5 2.2243 1.9860 1.77321 1.5832 21 315 36.9731 total numbers of years equivalent annual cost of investing 5.28 DECISION Since Equivalent cost of investing for expensive system is low as compared to the cheap system BLOOPER should 1 install expensive system EXPLANATION 1 present value factor calculated by using 1/(1+r)^n Formula 2 depreciation is calculated using, (cost/usefull years of life) since salvage value is given in the problem as 0 3 For initial capital investment there will not be any tax benefit.