Equivalent Annual Cost Bridgeton Golf Academy is evaluating new golf practice eq

Question

Equivalent Annual Cost Bridgeton Golf Academy is evaluating new golf practice equipment. The "Dimple-Max" equipment costs $64,000, has a three-year life, and costs $7,500 per year to operate. The relevant discount rate is 12 percent. Assume that the straight-line depreciation method is used and that the equipment is fully depreciated to zero.Furthermore, assume the equipment has a salvage value of $7,500 at the end of the project's life. The relevant tax rate is 34 percent. All cash flows occur at the end of the year. What is the equivalent annual costs (EAC) of the equipment? Show all steps.

Explanation / Answer

To find the EAC, we first need to calculate the NPV of the incremental cash flows. We will begin with the after-tax salvage value, which is :

After-tax Salvage value = (BV – MV)*(1-tax)

After-tax salvage value = ($0 – 7,500)(1 - 0.34)

After-tax salvage value $4,950

Now we can find the operating cash flows. Using the tax shield approach, the operating cash flow each year will be :

OCF = –$7,500(1 – 0.34) + 0.34($64,000 / 3)

OCF = $2,303.33

So, the NPV of the cost of the decision to buy is :

NPV = –$64,000 + $2,303.33(PVIFA12%,3) + ($4,950 / 1.12^3)

NPV = –$54,944.48

In order to calculate the equivalent annual cost, set the NPV of the equipment equal to an annuity with the same economic life. Since the project has an economic life of three years and is discounted at 12percent, set the NPV equal to a three-year annuity, discounted at 12 percent.

EAC = –$54,944.48 / (PVIFA12%,3)

EAC = –$22,876.08

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