Question

Using Excel: You were asked by the Manager of Engineering to propose a solution for a current production line problem. After analyzing the issues you came up with two solutions, both of which will solve the problem for the next five years. Solution A would initially cost $90,000, have annual O&M costs of $22,000 and will generate annual savings of $48,000, while solution B will need an initial $62,000, $17,000 for annual O&M costs, and will generate annual savings of $36,000. Both will have salvage values, $15,000 for solution A, and $10,000 for B. Your company's marginal income tax rate is 40%, and its MARR is 10%. The proposed equipment for both options is subject to a five-year MACRS property class.

a.What value of MARR would make each solution break even?

b.What would be the amount of additional revenue that Solution A should generate to make the Manager of Engineering indifferent to the choice between the two options?

Answer 1

Answer :

(a).

Calculation of the amount of MAAR at which solution Break Even
Sl No.	Particulars	Solution A	Solution A
1.	Initial cost	$ 90,000	$ 62,000
2.	Annual O$M Costs	$ 22,000	$ 17,000
3.	Annual Savings	$ 48,000	$ 36,000
4.	Salvage value	$ 15,000	$ 10,000
5.	Life in years	5	5
6.	Depreciation per annum	90000/5 = 18000	62000/5 =12400
7.	Net savings	48000-22000 = 26000	36000-17000 =19000
8.	Net Savings less Depreciation	26000-18000 =8000	19000-12400 = 6600
9.	Less Tax @40	8000*0.4 = 22800	6600*0.4 = 2640
10.	Net savings after tax but before depreciation	4800+18000 = 22800	3960+12400 = 16360
11.	Annuity Discounting factor MARR @ 10% for 5 years	3.791	3.791
12.	5th Year present value dis factor @ 10%	0.621	0.621
13.	Net Savings after tax but before depreciation @10%	3.791*22800 = 86435	3.791*16360 = 62021
14.	salvage value of 5th year @ 10%	0.621*15000 = 9315	0.621*15000 = 6210
15.	Total Savings	86435+9315 =95750	62021+6210=68231
16.	Net Present value	95750-90000 5750	68231-62000=6231
17.	NPV as a % od initial cost	5750/90000*100 = 6.39%	6231/62000*100=10.05%
18.	Internal rate of return- Break even	10%+6.39%=16.39%	10%+10.05%=20.05%

NOTES

The standard method of depreciation for federal income tax purposes is called the modified Accelerated cost recovery System or MACRS. Essentially a MACRS depreciation schedule will begin with a declining balance method then switch to a straight line schedule to finish the schedule.

(b).

Project A Yeari Year5 YearO Year2 Year3 Year4 particulars Cost Annual cost Saving Net saving(Saving-cost)(A)-90000 Salvage Tax on salvage 90,000.00 22,000.00 22,000.00 22,000.00 22,000.00 22,000.00 48,000.00 48,000.00 48,000.00 48,000.00 |48,000.00 26,000.00 26,000.00 26,000.00 26,000.00 26,000.00 15,000.00 6,000.00 9,000.00 90,000.00 26,000.00 26,000.00 26,000.00 26,000.00 35,000.00 After Tax salvage(B) Total Inflow Rate 10% Total inflow Net Inflow 1.000.90909 0.82645 0.75131 0.68301 0.62092 90,000.00 23,636.36 21,487.60 19,534.18 17,758.35 21,732.25 14,148.75

Project B Yearl Year2 Year4 YearO particulars Cost Annual cost Saving Net saving(Saving-cost) 62,000.00 19,000.00 19,000.00 19,000.00 19,000.00 19,000.00 Salvage Tax on salvage After Tax salvage(B) Total Inflow Year3 Year5 62,000.00 17,000.00 17,000.00 17,000.00 17,000.00 17,000.00 36,000.00 36,000.00 36,000.00 36,000.00 36,000.00 10,000.00 4,000.00 6,000.00 62,000.00 19,000.00 19,000.00 19,000.00 19,000.00 25,000.00 Rate 10% Total inflow Net Inflow 1.000.90909 0.826450.751310.68301 0.62092 62,000.00 17,272.73 15,702.48 14,274.98 12,977.26 15,523.03 13,750.48

Additional Revenue
	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5
Revenue from A		26,000.00	26,000.00	26,000.00	26,000.00	26,000.00
Revenue from B		19,000.00	19,000.00	19,000.00	19,000.00	19,000.00
Revenue income of A over B		7,000.00	7,000.00	7,000.00	7,000.00	7,000.00
Revenue from A is Already over and above B