Question

Hagar Industrial Systems Company (HISC) is trying to decide between two different conveyor belt systems. System A costs $200,000, has a four-year life, and requires $65,000 in pretax annual operating costs. System B costs $282,000, has a six-year life, and requires $59,000 in pretax annual operating costs. Both systems are to be depreciated straight-line to zero over their lives and will have zero salvage value. Whichever system is chosen, it will not be replaced when it wears out. The tax rate is 30 percent and the discount rate is 9 percent. Calculate the NPV for both conveyor belt systems. (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16. A negative answer should be indicated by a minus sign.) NPV System A? System B?

Answer 1

Solution.

In this question when we trying to decided between two project that will not be replaced when they are wear out.

in this case we can use proper capital budgeting method to use is NPV.

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:

Operating cash flow = -$65,000(1-.30) + .30 ($200,000 /4)

Operating cash flow = -$30,500

NPVa = -$200,000 -$30,500 x (PVIFA9%,4)

NPVa = $298,811.46

And the NPV of System B is:

OCFb = ?$59,000(1 ? .30) + .30($282,000 / 6)

OCFb = ?$27,200

NPVb = ? $282,000 ? $27,200(PVIFA 9%,6 )

NPVb = ? $404,016.99

If the system will not be replaced when it wears out, then System A should be chosen, because it has the less negative NPV.