Question

As a result of improvements in product engineering, United Automation is able to sell one of its two milling machines. Both machines perform the same function but differ in age. The newer machine could be sold today for $72,500. Its operating costs are $23,000 a year, but in five years the machine will require a $18,500 overhaul. Thereafter operating costs will be $31,500 until the machine is finally sold in year 10 for $7,250.

The older machine could be sold today for $26,500. If it is kept, it will need an immediate $27,500 overhaul. Thereafter operating costs will be $36,900 a year until the machine is finally sold in year 5 for $7,250.   

Both machines are fully depreciated for tax purposes. The company pays tax at 35%. Cash flows have been forecasted in real terms. The real cost of capital is 11%.

a. Calculate the equivalent annual costs for selling the new machine and for selling the old machine. (Do not round intermediate calculations. Enter your answers as a positive value rounded to 2 decimal places.)

	Equivalent Annual Cost
Sell new machine	$
Sell old machine	$

b. Which machine should United Automation sell?

     

	Sell old machine
	Sell new machine

Answer 1

ans.

a)

Option 1 : Sell the newer machine & keep the older machine (with tax)

Years	0	1	2	3	4	5
Proceeds from sale of old machine	$         72,500.00
Tax on gain @ 35%	$       (25,375.00)
Operating costs (new machine)		$    (36,900.00)	$    (36,900.00)	$    (36,900.00)	$    (36,900.00)	$    (36,900.00)
Overhaul expense	$       (27,500.00)
Proceeds from sale of new machine						$         7,250.00
Tax on gain @35%						$      (2,537.50)
Cash Flow	$         19,625.00	$    (36,900.00)	$    (36,900.00)	$    (36,900.00)	$    (36,900.00)	$    (32,187.50)
PV factor @ 11%	1	0.900900901	0.811622433	0.731191381	0.658730974	0.593451328
Present Value	$         19,625.00	$    (33,243.24)	$    (29,948.87)	$    (26,980.96)	$    (24,307.17)	$    (19,101.71)
Net Present Value	$ (113,956.96)

Equivalent Annual Cost (EAC) for 5 years

Present Value = EAC1 * PVAF @ 11% for 5 years

$113,956.96 = EAC1 * 3.6958970173

EAC1 = $113,956.96 / 3.6958970173 = $ 30,833.37

Option 2 : Sell the older machine & keep the newer machine (with tax)

Years	0	1	2	3	4	5	6	7	8	9	10
Proceeds from sale of old machine	$    26,500.00
Tax on gain @ 35%	$     (9,275.00)
Operating costs (new machine)		$ (23,000.00)	$ (23,000.00)	$ (23,000.00)	$ (23,000.00)	$ (23,000.00)	$ (31,500.00)	$ (31,500.00)	$ (31,500.00)	$ (31,500.00)	$ (31,500.00)
Overhaul expense						$ (18,500.00)
Proceeds from sale of new machine											$      7,250.00
Tax on gain @35%											$    (2,537.50)
Cash Flow	$    17,225.00	$ (23,000.00)	$ (23,000.00)	$ (23,000.00)	$ (23,000.00)	$ (41,500.00)	$ (31,500.00)	$ (31,500.00)	$ (31,500.00)	$ (31,500.00)	$ (26,787.50)
PV factor @ 11%	1	0.900900901	0.811622433	0.731191381	0.658730974	0.593451328	0.534640836	0.481658411	0.433926496	0.390924771	0.352184479
Present Value	$    17,225.00	$ (20,720.72)	$ (18,667.32)	$ (16,817.40)	$ (15,150.81)	$ (24,628.23)	$ (16,841.19)	$ (15,172.24)	$ (13,668.68)	$ (12,314.13)	$    (9,434.14)
Net Present Value	$ (146,189.86)

Equivalent Annual Cost (EAC) for 10 years

Present Value = EAC1 * PVAF @ 11% for 10 years

$146,189.86 = EAC1 * 5.88923201096

EAC1 = $146,189.86 / 5.88923201096 = $ 24,823.25

b)

Which machine should united automation sell?

Sell the old machine.

Because the Equivalent Annual Cost is less.