Question

The Fairmont Hotel in San Francisco needs to replace its air conditioning system. There are two alternatives, both of which can do the job equally well:

Machine name	AC 1	AC 2
Purchase price	$40,000	$60,000
Operating cost (end of each year)	$18,000	$8,000
Useful life (years)	4	5
Straight line depreciation to zero over (years)	4	5
Salvage value at end of useful life	$0	$0

The relevant discount rate is 10% and the marginal tax rate is 35%.

Part 1

What is the after-tax cash flow for AC 1 per year.

Part 2

What is the equivalent annual cost for AC 1 (in absolute terms)?

Part 3

What is the after-tax cash flow for AC 2 per year?

Part 4

What is the equivalent annual cost for AC 2 (in absolute terms)?

Answer 1

PART 1:
After tax operating cost [18000*(1-35%)]	-11700.00
Tax shield on depreciation [(40000/4)*35%]	3500.00
After tax cash flow per year	-8200.00
PART 2:
Equivalent annual purchase price = -40000*0.1*1.1^4/(1.1^4-1) =	-12618.832
After tax cash flow per year	-8200.00
Equivalent annual cost for AC 1	-20818.832
PART 3:
After tax operating cost [8000*(1-35%)]	-5200.00
Tax shield on depreciation [(60000/5)*35%]	4200.00
After tax cash flow per year	-1000.00
PART 4:
Equivalent annual purchase price = -60000*0.1*1.1^5/(1.1^5-1) =	-15827.849
After tax cash flow per year	-1000.00
Equivalent annual cost for AC 2	-16827.849
DECISION:
AC 2 is to be bought as its EAC is lower than that of AC 1.