Vandalay Industries is considering the purchase of a new machine for the product
ID: 2789610 • Letter: V
Question
Vandalay Industries is considering the purchase of a new machine for the production of latex. Machine A costs $2,100,000 and will last for 6 years. Variable costs are 39 percent of sales, and fixed costs are $162,000 per year. Machine B costs $4,430,000 and will last for 9 years. Variable costs for this machine are 27 percent of sales and fixed costs are $112,000 per year. The sales for each machine will be $8.86 million per year. The required return is 10 percent and the tax rate is 35 percent. Both machines will be depreciated on a straight-line basis.
Required: (a) If the company plans to replace the machine when it wears out on a perpetual basis, what is the EAC for machine A? (Do not round your intermediate calculations.)
(b) If the company plans to replace the machine when it wears out on a perpetual basis, what is the EAC for machine B? (Do not round your intermediate calculations.)
Explanation / Answer
CALCUALTION OF EQUALENT ANNUAL COST(EAC) OF MACHINE A:
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Particulars $
Variable cost ($8.86m x 39%) (-)$3,455,400
Fixed cost (-) 162,000
Depreciaiton ($2,100,000/6yrs) (-) 350,000
Income before tax (-) 3,967,400
Tax @35% 1,388,590
Net Income (-) 2,578,810
Add: Depreciaiton 350,000
Operating cash flows (-)2,228,810
Net present Value = (-) $ 2,100,000 - 2,228,810 (PVIF10%,6)
Net present value = (-) $2,100,000 - 2,228,810 x (4.3553)
Net present vlaue = (-) $2,100,000 - $9707137= 11,807,137
Equalent Annual cost (EAC) = NPV/(PVFI10%,6)) = (-)$11,807,137/4.3553 = (-) $2,710,981.33
CALCULATION OF EQUALENT ANNUAL COST (EAC) OF MACHINE B:
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Particulars $
Variable cost ($8.86m x 39%) (-)$2,392,200
Fixed cost (-) 112,000
Depreciaiton ($4,430,000/9yrs) (-) 492,222
Income before tax (-) 2,996,422
Tax @35% 1,048,748
Net Income (-)1,947,674
Add: Depreciaiton 492,222
Operating cash flows (-) 1,455,382
Net present Value = (-) $ 4,430,000 - 1,455,382 (PVIF10%,9)
Net present value = (-) $ 4,430,000 -1,455,382 x 5.7590)
Net present vlaue = (-) $4,430,000 - $8381545 = (-) $12,811,545
Equalent Annual cost (EAC) = NPV/(PVFI10%,9) = (-)$12,811,545/5.7590 = (-) $2,224,612.77
Note: PVIF = Present value Inflow factor = By referring annuity table, we can get the factor or we can use the followng formula
Annuity factor for $1 = 1 x (1+r)n -1/r(1+r)n where r= rate of return ie. 10% or 0.10; n = life of the project ie. 6 years in case of Machine A and 9 years in case of Machine B
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