CBOE Manufacturing is trying to decide between two different conveyor belt syste

Question

CBOE Manufacturing is trying to decide between two different conveyor belt systems. System A costs $408,000, has a 4-year life, and requires $125,000 in pretax annual operating costs. System B costs $515,000, has a 7-year life, and requires $73,000 in pretax annual operating costs. Both systems are to be depreciated straight-line to zero over their lives and will have zero salvage value. Whichever project is chosen, it will not be replaced when it wears out. If the tax rate is 34 percent and the discount rate is 17 percent, the NPV for project A is $ and the NPV for project B is $ . Therefore, the firm should choose project (Click to select)BA. (Do not include the dollar signs ($). Negative amounts should be indicated by a minus sign. Round your answers to 2 decimal places. (e.g., 32.16))

Explanation / Answer

Hi,

Please find the answer as follows:

System A:

Initial Investment = -408000

Annual Cash Flows = (Pretax Annual Operating Cost + Depreciation)(Tax Rate) = (125000 + 408000/4)*(.34) = -77180

NPV = -408000 - 77180/(1+.17)^1 - 77180/(1+.17)^2 - 77180/(1+.17)^3 - 77180/(1+.17)^4 = -619722.88

System B:

Initial Investment = -515000

Annual Cash Flows = (Pretax Annual Operating Cost + Depreciation)(Tax Rate) = (73000 + 515000/7)*(.34) = -49834.29

NPV = -515000 - 49834.29/(1+.17)^1 - 49834.29/(1+.17)^2 - 49834.29/(1+.17)^3 - 49834.29/(1+.17)^4 - 49834.29/(1+.17)^5 - 49834.29/(1+.17)^6 - 49834.29/(1+.17)^7 = -710469.01 or -710469.03 (there could be a small difference on account of approxmations)

The firm should accept System A as it has lower NPV in terms of cost.

Thanks.

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