Question

Blooper Industries must replace its magnoosium purification system. Quick & Dirty Systems sells a relatively cheap purification system for $12 million. The system will last 4 years. Do-It-Right sells a sturdier but more expensive system for $13 million; it will last for 5 years. Both systems entail $2 million in operating costs; both will be depreciated straight-line to a final value of zero over their useful lives; neither will have any salvage value at the end of its life. The firm’s tax rate is 30%, and the discount rate is 15%. Either machine will be replaced at the end of its life.

a. What is the equivalent annual cost of investing in the cheap system? (Do not round intermediate calculations. Enter your answer as a positive value. Enter your answer in millions rounded to 2 decimal places.)

b. What is the equivalent annual cost of investing in the more expensive system? (Do not round intermediate calculations. Enter your answer as a positive value. Enter your answer in millions rounded to 2 decimal places.)

c. Which system should Blooper install?

Answer 1

(a)

	Year	Amount	PVF@15%	Discounted value
Initital investment	0	12	1	12
Cash outflow p.a.[(2 + 3) x (1 - 0.30)]	1-4	3.50	2.855	9.99
Total cash outflow				21.99
Divide by: PVF@15% for 4years				2.855
Equivalent annual cost				$7.70 million

(b)

	Year	Amount	PVF@15%	Discounted value
Initital investment	0	13	1	13
Cash outflow p.a.[(2 + 2.60) x (1 - 0.30)]	1-5	3.22	3.352	10.79
Total cash outflow				23.79
Divide by: PVF@15% for 5years				3.352
Equivalent annual cost				$7.10 million

(c) Install the Sturdier system as its equivalent annual cost is lower