You are evaluating two different silicon milling machines: A. The Techron I cost
ID: 1194769 • Letter: Y
Question
You are evaluating two different silicon milling machines:
A. The Techron I costs $215,000, has a three-year life, and a pre-tax operating costs of $35,000 per year.
B. The Techron II costs $270,000, has a five-year life, and has pre-tax operating costs of $44,000 per year.
For both milling machines, use straight-line depreciation to zero over a the project’s life and assume a salvage value of $20,000. If your tax rate is 35% and your discount rate is 12 percent, compare the EAC for both machines. Which do you prefer? Why?
Explanation / Answer
Working notes:
(1) SLM Depreciation = (Cost - Salvage value) / useful life
Techron I: $(215,000 - 20,000) / 3 = $195,000 / 3 = $65,000
Techron II: $(270,000 - 20,000) / 5 = $250,000 / 5 = $50,000
(2) Total pre-tax cost = Operating costs + Depreciation
Techron I: $(35,000 + 65,000) = $100,000
Techron II: $(44,000 + 50,000) = $94,000
(3) After-tax cost = Pre-tax total cost x (1 - Tax rate) = Pre-tax total cost x (1 - 0.35) = 0.65 x Pre-tax total cost
Techron I: $100,000 x 0.65 = $65,000
Techron II: $94,000 x 0..65 = $61,100
(4) EAC = First Cost x A/P(r%, N years)** + Annual after-tax cost = First cost x A/P(12%, N years) + Annual after-tax cost
Techron I: $215,000 x A/P(12%, 3 years) + $65,000 = $215,000 x 0.42 + $65,000 = $(90,300 + 65,000) = $155,300
Techron II: $270,000 x A/P(12%, 5 years) + $61,100 = $270,000 x 0.28 + $61,100 = $(75,600 + 61,100) = $136,700
Since EAC is lower for Techron II, this machine is preferred.
NOTE: If the question asked for cash flow analysis, Depreciation (being a non-cash expense) would have been added back to Total pre-tax annual cost. But the question asks for EAC & it has been answered assuming depreciation will be treated as other cash expenses, and therefore is not added back. Answer might be different with depreciation added back & treated differently.
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