You are evaluating two different silicon wafer milling machines. The Techron I costs $222,000, has a three-year life, and has pretax operating costs of $57,000 per year. The Techron II costs $390,000, has a five-year life, and has pretax operating costs of $30,000 per year. For both milling machines, use straight-line depreciation to zero over the project’s life and assume a salvage value of $34,000. If your tax rate is 35 percent and your discount rate is 9 percent, compute the EAC for both machines.

You are evaluating two different silicon wafer milling machines. The Techron I costs $222,000, has a three-year life, and has pretax operating costs of $57,000 per year. The Techron II costs $390,000, has a five-year life, and has pretax operating costs of $30,000 per year. For both milling machines, use straight-line depreciation to zero over the project’s life and assume a salvage value of $34,000. If your tax rate is 35 percent and your discount rate is 9 percent, compute the EAC for both machines. (Negative amounts should be indicated by a minus sign. Do not round intermediate calculations and round your final answers to 2 decimal places. (e.g., 32.16))

	EAC
Techron I	$
Techron II	$

Which do you prefer?

Techron II

Explanation:

We will need the aftertax salvage value of the equipment to compute the EAC. Even though the equipment for each product has a different initial cost, both have the same salvage value. The aftertax salvage value for both is:

Aftertax salvage value = $34,000(1 − 0.35) = $22,100

To calculate the EAC, we first need the OCF and NPV of each option. The OCF and NPV for Techron I is:

OCF = −$57,000(1 − 0.35) + 0.35($222,000/3) = −$11,150

NPV = −$222,000 − $11,150(PVIFA9%,3) + ($22,100/1.093) = −$233,158.68

EAC = −$233,158.68 / (PVIFA9%,3) = −$92,110.45

And the OCF and NPV for Techron II is:

OCF = −$30,000(1 − 0.35) + 0.35($390,000/5) = $7,800

NPV = −$390,000 + $7,800(PVIFA9%,5) + ($22,100/1.095) = −$345,297.24

EAC = −$345,297.24 / (PVIFA9%,5) = −$88,773.31

The two milling machines have unequal lives, so they can only be compared by expressing both on an equivalent annual basis, which is what the EAC method does. Thus, you prefer the Techron II because it has the lower (less negative) annual cost.

Dog Up! Franks is looking at a new sausage system with an installed cost of $460,000. This cost will be depreciated straight-line to zero over the project’s five-year life, at the end of which the sausage system can be scrapped for $66,000. The sausage system will save the firm $230,000 per year in pretax operating costs, and the system requires an initial investment in net working capital of $25,000. If the tax rate is 30 percent and the discount rate is 8 percent, what is the NPV of this project?

Dog Up! Franks is looking at a new sausage system with an installed cost of $460,000. This cost will be depreciated straight-line to zero over the project’s five-year life, at the end of which the sausage system can be scrapped for $66,000. The sausage system will save the firm $230,000 per year in pretax operating costs, and the system requires an initial investment in net working capital of $25,000. If the tax rate is 30 percent and the discount rate is 8 percent, what is the NPV of this project? (Do not round intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16))

NPV

$

Explanation:

First we will calculate the annual depreciation of the new equipment. It will be:

Annual depreciation = $460,000/5

Annual depreciation = $92,000

Now, we calculate the aftertax salvage value. The aftertax salvage value is the market price minus (or plus) the taxes on the sale of the equipment, so:

Aftertax salvage value = MV + (BV − MV)T

Very often the book value of the equipment is zero as it is in this case. If the book value is zero, the equation for the aftertax salvage value becomes:

   

Aftertax salvage value = MV + (0 − MV)T

Aftertax salvage value = MV(1 − T)

We will use this equation to find the aftertax salvage value since we know the book value is zero. So, the aftertax salvage value is:

Aftertax salvage value = $66,000(1 − 0.30)

Aftertax salvage value = $46,200

Using the tax shield approach, we find the OCF for the project is:

OCF = $230,000(1 − 0.30) + 0.30($92,000)

OCF = $188,600

Now we can find the project NPV. Notice we include the NWC in the initial cash outlay. The recovery of the NWC occurs in Year 5, along with the aftertax salvage value.

NPV = −$460,000 − 25,000 + $188,600(PVIFA8%,5) + [($46,200 + 25,000) / 1.085]

NPV = $316,482.64

Keiper, Inc., is considering a new three-year expansion project that requires an initial fixed asset investment of $2.49 million. The fixed asset will be depreciated straight-line to zero over its three-year tax life, after which time it will be worthless. The project is estimated to generate $2,010,000 in annual sales, with costs of $705,000. The tax rate is 34 percent and the required return on the project is 16 percent. What is the project’s NPV?

Keiper, Inc., is considering a new three-year expansion project that requires an initial fixed asset investment of $2.49 million. The fixed asset will be depreciated straight-line to zero over its three-year tax life, after which time it will be worthless. The project is estimated to generate $2,010,000 in annual sales, with costs of $705,000. The tax rate is 34 percent and the required return on the project is 16 percent. What is the project’s NPV? (Round your answer to 2 decimal places. (e.g., 32.16))

NPV

$

Explanation:

Using the tax shield approach to calculating OCF (Remember the approach is irrelevant; the final answer will be the same no matter which of the four methods you use.), we get:

OCF = (Sales − Costs)(1 − T) + T(Depreciation)

OCF = ($2,010,000 − 705,000)(1 − 0.34) + 0.34($2,490,000/3)

OCF = $1,143,500

Since we have the OCF, we can find the NPV as the initial cash outlay plus the PV of the OCFs, which are an annuity, so the NPV is:

NPV = −$2,490,000 + $1,143,500(PVIFA16%,3)

NPV = $78,174.69

Keiper, Inc., is considering a new three-year expansion project that requires an initial fixed asset investment of $2.76 million. The fixed asset will be depreciated straight-line to zero over its three-year tax life, after which time it will be worthless. The project is estimated to generate $2,100,000 in annual sales, with costs of $795,000. If the tax rate is 34 percent, what is the OCF for this project?

Keiper, Inc., is considering a new three-year expansion project that requires an initial fixed asset investment of $2.76 million. The fixed asset will be depreciated straight-line to zero over its three-year tax life, after which time it will be worthless. The project is estimated to generate $2,100,000 in annual sales, with costs of $795,000. If the tax rate is 34 percent, what is the OCF for this project? (Enter your answer in dollars, not millions of dollars, i.e. 1,234,567.)

OCF

$

Explanation:

Using the tax shield approach to calculating OCF (Remember the approach is irrelevant; the final answer will be the same no matter which of the four methods you use.), we get:

OCF = (Sales − Costs)(1 − T) + T(Depreciation)

OCF = ($2,100,000 − 795,000)(1 − 0.34) + 0.34($2,760,000/3)

OCF = $1,174,100

Fill in the missing numbers for the following income statement.

Fill in the missing numbers for the following income statement. (Input all amounts as positive values.)

Sales	$	691,900
Costs		446,800
Depreciation		119,400
EBIT	$
Taxes (34%)
Net income	$

Calculate the OCF.

OCF

$

What is the depreciation tax shield?

Depreciation tax shield

$

Explanation:

The OCF for the company is:

OCF = EBIT + Depreciation − Taxes

OCF = $125,700 + 119,400 − 42,738

OCF = $202,362

The depreciation tax shield is the depreciation times the tax rate, so:

Depreciation tax shield = T(Depreciation)

Depreciation tax shield = 0.34($119,400)

Depreciation tax shield = $40,596

The depreciation tax shield shows us the increase in OCF by being able to expense depreciation.