PB International Company is trying to decide between two different plant systems
ID: 2668617 • Letter: P
Question
PB International Company is trying to decide between two different plant systems. Plant 1 $360,000 has a 4-year life and requires $105,000 in pretax annual operating costs. Plant 2 costs $480,000, has a 6-year life and requires $65,000 in pre-tax annual operating costs. Both plants are to be depreciated straight-line to zero over their lives and will have zero salvage value. Whichever plant is chosen, it will not be replaced when it wears out. If the tax rate is 34% and the discount rate is 11%, which plant should the company choose?Explanation / Answer
Plant 1:
Project cost = $360,000
Life time = 4 years
Pre-tax annual operating cost = $105,000
Plant 2:
Project Cost = $480,000
Life time = 6 years
Pre-tax annual operating cost = $65,000
Tax rate = 34%
Discount rate = 11%
Calculating Present value Costs:
After-tax Operating Cost of Plant 1 = [$105,000 – ($105,000 * 0.34)]
After-tax Operating Cost of Plant 1 = [$105,000 - $35,700]
After-tax Operating Cost of Plant 1 = $69,300
Calculating Present Value of Operating Costs:
(Using Ms-Excel "PV" Function):
Interest rate (or) Discount rate (Rate)
11%
Number of years (or) Number of Periods (Nper)
4
After-tax Operating costs (PMT)
-69300
Present value of After-tax Operating Costs (PV)
$214,999.49
Present value of total cost of Plant 1 = $214,999.49 + $360,000
Present value of total cost of Plant 1 = $574,999.49
Plant 2:
After-tax Operating Cost of Plant 2 = [$65,000 – ($65,000 * 0.34)]
After-tax Operating Cost of Plant 1 = [$65,000 - $22,100]
After-tax Operating Cost of Plant 1 = $42,900
Calculating Present Value of Operating Costs:
(Using Ms-Excel "PV" Function):
Interest rate (or) Discount rate (Rate)
11%
Number of years (or) Number of Periods (Nper)
6
After-tax Operating costs (PMT)
-42900
Present value of After-tax Operating Costs (PV)
$181,490.07
Present value of total cost of Plant 2 = $181,490.07 + $480,000
Present value of total cost of plant 2 = $661,490.07
Present value of total cost of Plant 1 = $574,999.49
Present value of total cost of Plant 2 = $661,490.07
Note: Comparing these two Plants, Plant 1 has got lowest present value. Hence, Plant 1 is preferable for selection.
Calculating Present Value of Operating Costs:
(Using Ms-Excel "PV" Function):
Interest rate (or) Discount rate (Rate)
11%
Number of years (or) Number of Periods (Nper)
4
After-tax Operating costs (PMT)
-69300
Present value of After-tax Operating Costs (PV)
$214,999.49
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