Question

You are evaluating two different silicon wafer milling machines. The Techron I costs $270,000, has a three-year life, and has pretax operating costs of $69,000 per year. The Techron II costs $475,000, has a five-year life, and has pretax operating costs of $36,000 per year. For both milling machines, use straight-line depreciation to zero over the project's life and assume a salvage value of $45,000. If your tax rate is 35 percent and your discount rate is 10 percent, compute the EAC for both machines. Which do you prefer? Why?

Answer 1

The calculation of Equivalent Annual Cost (EAC) shows Techron II as the more cost-effective option with an EAC of $14,500 compared to Techron I's EAC of $50,250.

Step-by-step explanation:

To evaluate the two different silicon wafer milling machines, we need to calculate the Equivalent Annual Cost (EAC) for both machines. The EAC allows us to compare the cost-effectiveness of each machine by spreading out the costs over their respective lifespans.

Calculation for Techron I:

Initial cost: $270,000

Salvage value: $45,000

Depreciation: ($270,000 - $45,000) / 3 years = $75,000 per year

Operating costs: $69,000 per year

Depreciation tax shield: $75,000 * 35% = $26,250 per year

Total annual cost: Operating costs - tax shield = $69,000 - $26,250 = $42,750

EAC = Total annual cost + (Depreciation * discount rate)

EAC = $42,750 + ($75,000 * 10%) = $42,750 + $7,500 = $50,250

Calculation for Techron II:

Initial cost: $475,000

Salvage value: $45,000

Depreciation: ($475,000 - $45,000) / 5 years = $86,000 per year

Operating costs: $36,000 per year

Depreciation tax shield: $86,000 * 35% = $30,100 per year

Total annual cost: Operating costs - tax shield = $36,000 - $30,100 = $5,900

EAC = Total annual cost + (Depreciation * discount rate)

EAC = $5,900 + ($86,000 * 10%) = $5,900 + $8,600 = $14,500

Considering the calculations, Techron II has a lower EAC and hence is the more cost-effective choice over its lifespan.