Question

You are evaluating two different aluminum milling machines. The Alumina I costs $240,000, has a three-year life, and has pretax operating costs of $63,000 per year. The Alumina II costs $420,000, has a five-year life, and has pretax operating costs of $36,000 per year. For both milling machines, use straight-line depreciation to zero over the project's life and assume a salvage value of $40,000. If your tax rate is 35 percent and your discount rate is 10 percent, which do you prefer? Why? Answer this question using Microsoft Excel. Mark the key equations and write them out.

Answer 1

The operational and investment cost on an asset every year until the asset is disposed out is known as equivalent annual cost of an asset. This is the technique which is used to compare the assets before investment.

Calculation of equivalent annual costs for deciding which company should be preferable:

$ $ 2.40.000 63,000 Alumina I: Cost Operating costs per year Life Alumina II : Cost Operating costs per year Life Both: Salvage value Tax rate Discount rate *Depreciation straight-line $ S 4,20,000 36,000 S 40,000 35% 10%

$ 26,000.00 Both cases: Aftertax salvage value Alumina I: OCF NPV EAC Alumina II: OCF NPV EAC $ (12.950.00) S(2.52.670.55) $(1,01,602.57) $ 6,000.00 $(3.81.111.32) $(1,00,536.21)

According to the given question, both the machines have unequal lives so for taking the decision regarding the preference, equivalent annual costs should be evaluated and the value of lower negative cost should be considered. Therefore, Alumina II should be prefer because this machine has lower negative equivalent annual cost.