Question

Gluon Inc. is considering the purchase of a new high pressure glueball. It can purchase the glueball for $120,000 and sell its old low-pressure glueball, which is fully depreciated, for $20,000. The new equipment has a 10-year useful life and will save $28,000 a year in expenses. The opportunity cost of capital is 12%, and the firm’s tax rate is 40%. What is the equivalent annual savings from the purchase if Gluon uses straight-line depreciation? Assume the new machine will have no salvage value. (Do not round intermediate calculations. Round your answer to 2 decimal places.)

Answer 1

In case straight line depreciation, Annual depreciation = 120,000/10= $12,000

Annual depreciation tax shield = $12,000*40% = $4,800

The present value of cost of buying, net of annual depreciation tax shield = $ 120,000 – [4800 * Annuity factor (12%, 10 years) = $ 120,000 - $ 4,800 * 5.6502 = $92,879.04

The Equivalent annual Cost (EAC)

• EAC * Annuity factor (12%,10 years) = $92,879.04
• EAC = $92,879.04/ 5.6502 = $16,438.19.

After Tax annual Saving = $ 28,000 (1-0.40) =$16,800

Net Equivalent annual saving from purchase = $16,800 - $16,438.19 = $ 361.82