(Equivalent annual cost calculation) The Templeton Manufacturing and Distributio

Question

(Equivalent annual cost calculation) The Templeton Manufacturing and Distribution Company of Tacoma, Washington, is contemplating the purchase of a new conveyor belt system for one of its regional distribution facilities. Both alternatives will accomplish the same task but the Eclipse Model is substantially more expensive than the Sabre Model and will not have to be replaced for 10 years, whereas the cheaper model will need to be replaced in just 5 years. The costs of purchasing the two systems and the costs of operating them annually over their expected lives is provided below. a. Templeton typically evaluates investments in plant improvements using a required rate of return of 8 percent. What are the NPVs for the two systems? b. Calculate the equivalent annual costs for the two systems c. Based on your analysis of the two systems using both their NPV and EAC, which system do you recommend the company pick? Why? Data Table Year (1,350,000) (24,000) (29,000) (29,000) (29,000) (38,000) (38,000) S(750,000) (55,000) (55,000) (63,000) (63,000) (85,000) (38,000) (38,000) Print Done

Explanation / Answer

The following formula is used for EAC calculation-

Equivalent Annual Cost EAC = (r*NPV)/ (1-(1+r) ^-n)

Where,

Project’s net present value is NPV

Cost of capital of the corporation is r

Time period of the project is n

(a) Let’s first calculate the NPV of Both Models:

Note: Assumed that Sabre Model will be replaced in 5 years with same cash flow

(b) Equivalent Annual Cost (EAC) calculation:

EAC of Eclipse = (r*NPV)/ (1-(1+r) ^-n) = (8%*-$1,570,544)/ (1-(1+8%) ^-10)

=-$234,057

EAC of Sabre = (r*NPV)/ (1-(1+r) ^-n) = (8%* -$1,684,360)/ (1-(1+8%) ^-10)

= -$251,019

Therefore Eclipse model is better choice because of lower Equivalent Annual cost (EAC) of -$234,057 than Sabre Model which has EAC -$251,019

(c) Based on Net present value (NPV) and Equivalent Annual cost (EAC) Eclipse model is better choice than Sabre Model

Year Eclipse Sabre Formula for PV PV of Eclipse's cash Flows PV of Sabre's cash Flows 0 -$1,350,000 -$750,000 CF/(1+8%)0 -$1,350,000 -$750,000 1 -$24,000 -$55,000 CF/(1+8%)1 -$22,222 -$50,926 2 -$29,000 -$55,000 CF/(1+8%)2 -$24,863 -$47,154 3 -$29,000 -$63,000 CF/(1+8%)3 -$23,021 -$50,011 4 -$29,000 -$63,000 CF/(1+8%)4 -$21,316 -$46,307 5 -$38,000 -$835,000 CF/(1+8%)5 -$25,862 -$568,287 6 -$38,000 -$55,000 CF/(1+8%)6 -$23,946 -$34,659 7 -$38,000 -$55,000 CF/(1+8%)7 -$22,173 -$32,092 8 -$38,000 -$63,000 CF/(1+8%)8 -$20,530 -$34,037 9 -$38,000 -$63,000 CF/(1+8%)9 -$19,009 -$31,516 10 -$38,000 -$85,000 CF/(1+8%)10 -$17,601 -$39,371 Discount Rate 8% 8% NPV (Sum of PVs) -$1,570,544 -$1,684,360 EAC -$234,057 -$251,019

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