Question

Letang Industrial Systems Company (LISC) is trying to decide between two different conveyor belt systems. System A costs $270,000, has a four-year life, and requires $77,000 in pretax annual operating costs. System B costs $350,000, has a six-year life, and requires $71,000 in pretax annual operating costs. Suppose the company always needs a conveyor belt system; when one wears out, it must be replaced. Assume the tax rate is 21 percent and the discount rate is 8 percent. Calculate the EAC for both conveyor belt systems. (A negative answer should be indicated by a minus sign. Do not round intermediate calculations and round your answers to 2 decimal places, e.g., 32.16.) Which conveyor belt system should the firm choose

Answer 1

System B

Step-by-step explanation:

Both projects only have costs associated with them, not sales, so we will use these to calculate the NPV of each project. Using the tax shield approach to calculate the OCF, the NPV of System A is:

OCFA = −$76,000(1 − .35) + .35($244,000 / 4)

OCFA = −$28,050.00

NPVA = −$244,000 − $28,050.00(PVIFA10%,4)

NPVA = −$332,914.73

And the NPV of System B is:

OCFB = −$70,000(1 − .35) + .35($342,000 / 6)

OCFB = −$25,550.00

NPVB = −$342,000 − $25,550.00(PVIFA10%,6)

NPVB = −$453,276.91

If the equipment will be replaced at the end of its useful life, the correct capital budgeting technique is EAC. Using the above NPVs, the EAC for each system is:

EACA = -$332,914.73 / (PVIFA10%,4)

EACA = -$105,024.88

EACB = - $453,276.91 / (PVIFA10%,6)

EACB = -$104,075.72

If the conveyor belt system will be continually replaced, we should choose System B since it has the more positive EAC.