Question

You are a recycler of spent plutonium rods from nuclear reactors, and a new government mandate requires you to purchase a filtration system for your wastewater. You can choose between two filtration systems.

Filtration System 1 has a four-year life and costs 600,000. It has an annual pre-tax operating cost of $50,000 in the first year. The filtration system will become less efficient with the passage of time. As a result, operating costs are expected to increase 5% per year over the Filtration System’s life.
Filtration System 2 has a six-year life and costs $360,000. It has an annual pre-tax operating cost of $40,000 in the first year. The operating efficiency of this filtration system will deteriorate faster than Filtration System 1. As a result, operating costs are expected to increase 8% per year over the Filtration System’s life.
You do not foresee any further changes in environmental laws or changes in water filtration technology. Both Filtration Systems have zero salvage values. The CCA rate for Filtration Systems is 50%, the corporate tax rate is 40% and the appropriate discount rate (RRR) is 11%.
a. What is the NPV of Filtration System 1?
b. What is the NPV of Filtration System 2?
c. What is Filtration System 1's EAC?
d. What is Filtration System 2's EAC?
e. Which Filtration System should you buy?
f. Do you need your results from c. and d. in order to answer question e?

Answer 1

To determine which filtration system to purchase, the NPV and EAC for each option need to be calculated, considering initial costs, operating costs, increase in operating costs over time, and the given CCA rate, tax rate, and discount rate.

Step-by-step explanation:

To determine which filtration system should be purchased, the Net Present Value (NPV) and the Equivalent Annual Cost (EAC) for each option need to be calculated. In this scenario, the corporate tax rate, Capital Cost Allowance (CCA) rate for Filtration Systems, and discount rate are provided. Also specified are the initial costs and the increase in operating costs over time for both Filtration System 1 and Filtration System 2.

Performing the NPV calculation will involve finding the present value of the costs and savings across the useful life of each system, taking into account the increase in operating costs, tax deductions from CCA, and discounting the values using the given discount rate. Once the NPV is determined, the EAC can be calculated. It is important to note that the cost efficiencies and increases in operating costs will directly affect these calculations. EAC expresses the cost of owning and operating each system on an annual basis, allowing for a comparison of two investments with different lifespans.

To decide which filtration system to purchase, you would typically compare the NPV or EAC of both options. The system with the lower EAC or higher (less negative) NPV would generally be the preferred choice. However, additional factors such as reliability, maintenance schedules, and impact on production may also influence the final decision.

The provided data on changes in environmental laws, water filtration technology stability, and details about the operation and efficiency decline of the systems are essential for an accurate assessment. These considerations ensure the decision is not only based on immediate costs but also on expected future conditions.