Question

As a result of improvements in product engineering, United Automation is able to sell one of its two milling machines. Both machines perform the same function but differ in age. The newer machine could be sold today for $72,500. Its operating costs are $23,000 a year, but at the end of five years, the machine will require a $18,500 overhaul (which is tax deductible). Thereafter, operating costs will be $31,500 until the machine is finally sold in year 10 for $7.250. The older machine could be sold today for $26,500. If it is kept, it will need an immediate $27,500 (tax-deductible) overhaul. Thereafter, operating costs will be $36,900 a year until the machine is finally sold in year 5 for $7,250. Both machines are fully depreciated for tax purposes. The company pays tax at 21%. Cash flows have been forecasted in real terms. The real cost of capital is 11%. a. Calculate the equivalent annual costs for selling the new machine and for selling the old machine. (Do not round intermediate calculations. Enter your answers as a positive value rounded to 2 decimal places.) Equivalent Annual Cost Sell new machine Sell old machine ſ b. Which machine should United Automation sell? Sell old machine Sell new machine

Answer 1

a)

Statement showing Equivalent annual cost of selling machine of new machine

Particulars	0	1	2	3	4	5	6	7	8	9	10	Total
Opportunity loss from sale of new machine =72500(1-tax rate) =72500(1-21%) =72500(1-0.21) =72500(0.79) =57275$	-57275
Operating cost		-23000	-23000	-23000	-23000	-23000	-31500	-31500	-31500	-31500	-31500
Overhaul expense						-18500
Total tax deductible cost		-23000	-23000	-23000	-23000	-41500	-31500	-31500	-31500	-31500	-31500
Tax Shield @ 21%		4830	4830	4830	4830	8715	6615	6615	6615	6615	6615
After tax cost		-18170	-18170	-18170	-18170	-32785	-24885	-24885	-24885	-24885	-24885
Salvage value of machine =7250(1-tax rate) =7250(1-21%) =7250(1-0.21) =7250(0.79) =5727.5$											5727.5
Total cash flow	-57275	-18170	-18170	-18170	-18170	-32785	-24885	-24885	-24885	-24885	-19157.5
PVIF @ 11%	1	0.9009	0.8116	0.7312	0.6587	0.5935	0.5346	0.4817	0.4339	0.3909	0.3522
PV	-57275.00	-16369.37	-14747.18	-13285.75	-11969.14	-19456.30	-13304.54	-11986.07	-10798.26	-9728.16	-6746.97	-185666.74
PVIFA(11%,10)												5.8892
Equivalent cost of selling machine (-185666.74/5.8892)												-31526.48

Thus Equivalent annual cost of selling machine of new machine = $31526.48

Statement showing Equivalent annual cost of selling machine of old machine

Particulars	0	1	2	3	4	5	Total
Opportunity loss from sale of new machine =26500(1-tax rate) =26500(1-21%) =26500(1-0.21) =26500(0.79) =57275$	-20935
Overhaul expense =27500(1-tax rate) =27500(1-0.21) =27500(0.79) =21725	-21725
Operating cost		-36900	-36900	-36900	-36900	-36900
Tax Shield @ 21%		7749	7749	7749	7749	7749
After tax cost		-29151	-29151	-29151	-29151	-29151
Salvage value of machine =7250(1-tax rate) =7250(1-21%) =7250(1-0.21) =7250(0.79) =5727.5$						5727.5
Total cash flow	-42660	-29151	-29151	-29151	-29151	-23423.5
PVIF @ 11%	1	0.9009	0.8116	0.7312	0.6587	0.5935
PV	-42660.00	-26262.16	-23659.61	-21314.96	-19202.67	-13900.71	-147000.10
PVIFA(11%,10)							3.6959
Equivalent cost of selling machine (-147000.10/3.6959)							-39773.86

Thus Equivalent annual cost of selling machine of new machine = $39773.86

b) Since old machine has more Equivalent annual cost, it should be sold