Granite Construction Co. is assessing whether is should replace or overhaul its
ID: 1197966 • Letter: G
Question
Granite Construction Co. is assessing whether is should replace or overhaul its four-year-old earth moving equipment. The overhaul costs $8000 and would extend the life of the existing equipment by 4 years. Annual operating costs would then amount to $25000. The current market value of the existing equipment is $2000, but if overhauled and retained for another 4 years, it would have no recoverable value. New equipment costs $20,000, has a useful life of 6 years, relatively constant annual operating costs of $1500, and a salvage value of $3300. Assume that the firm requires a 15% return on investment and uses equipment annual operating cost (EAOC) to assess equipment replacement options. Determine the equivalent annual after-tax cost of the new equipment over its useful life of 6 yrs. [$6,407] Based on the cost characteristics of the new equipment given above, what should be its economic life? Justify your answer. [The economic life is the useful life, i.e. 6 yrs, because the annual operating costs remain relatively constant] Determine the equivalent annual after-tax cost of the overhauled equipment over its life of 4 years. [$4,602] Which alternative is preferred? Justify your answer. [The overhaul alternative is preferred because of its lower EAOC]Explanation / Answer
A.
Initial cost of new machine = $20000
Useful life (n) = 6 years
Annual operating cost = $1500
Salvage Value = $3300
Discount rate (R)= 15%
Present value of total cost = initial cost + present value of annual operating cost – Present value of salvage value
Present value of total cost = 20000 + 1500*(1-1/(1+R)^n)/R – 3300/(1+R)^n
Present value of total cost = 20000 + 1500*(1-1/1.15^6)/.15 - 3300/1.15^6
Present value of total cost = $24250.04
Now,
Present value of total cost = $24250.04 = EAOC*(1-1/1.15^6)/.15
24250.04 = EAOC*3.7844
EAOC = 24250.04 / 3.7844
EAOC = $6407.89 or $6407
B.
Economic life is considered to be the useful life of the machine or equipment. In the given case, it is 6 years as mentioned in the question. Also, EAOC in part A is calculated on the basis of this useful life that has already considered the salvage value.
C.
Life (n) = 4 years
Present value of the total cost in overhauling = present value of the overhaul cost - current salvage value + present value of annual maintenance cost
Present value of the total cost in overhauling = 8000 -2000 + 2500*(1-1/(1+R)^n)/R
Present value of the total cost in overhauling = 6000+ 2500*(1-1/1.15^4)/.15
Present value of the total cost in overhauling = $13137.45
Now,
Present value of the total cost in overhauling = $13137.45 = EAOC*(1-1/1.15^4)/.15
13137.45 = EAOC*(1-1/1.15^4)/.15 =EAOC*2.8549
EAOC = 13137.45 / 2.8549
EAOC = $4601.6 or $4602 approx.
D.
Alternative of overhauling process is preferred because it has lower EAOC in comparison to the EAOC of new machine.
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