Question

Kayler Construction Co. must choose between two sources of heavy-duty drilling equipment. Drill A costs $7,500 and will be depreciated straight line over its five year life. The (pre-tax) maintenance costs for Drill A are $150 per year. In contrast, Drill B costs $9,000 and will be depreciated straight line over its sevenyear life. The (pre-tax) maintenance costs for Drill B are $120 per year. You should assume that Kayler must have this type of drilling equipment to stay in business, so whichever drill they buy, they will replace it when it wears out. Each drill will have zero salvage value at the end of its useful life. The required rate of return for Kayler Construction is 8.5 percent and the tax rate is 21%. Which drill should Kayler purchase and why?

Answer 1

IF ANY QUERY, FEEL FREE TO ASK IN COMMENTS Solution: Drill A analysis: Depreciation = = = 1500 Cost - Salvage Life 7500 -0 5 7500 5 Total After Tax Year Expense Dep. CFSP CEC PVF @ Present Expense Expense 8.5% Value 7500 75001 7500.00 1 150 1500 | 16501 1303.5| -196.5 0.922 -181.11 2 L 150 1500 1650 1303.5| -196.51 0.849 -166.92 3 150 1500 1650 1303.5 -196.5 0.783 -153.84 4 150 1500 1650 1303.5 -196.5 0.722 -141.79 1 5 150 1500 1650 1303.5 -196.5 0.665 -130.68 NPV 6725.66 PVAF 3.9406 Equated Annual Cost (EAC) 1706.74 where, Total Expense Expense + Dep. After Tax Expense Total Expense X (1 - Tax Rate) CFSP Cashflow due to Drill Salvage cashflow = Salvage X (1 - Tax rate) CFC After Tax Expense - Depreciation + CFSP PVAF (1+r)^n - 1 rX (1+r)^n PVF [1/(1+r)]^n where ris required rate of return and n is life of drill Present Value CFC X PVAF EAC Net Present Value PVAF Drill A analysis: Depreciation = 9000 -0 = 9000 1285.71 Cost - Salvage Life Year Expense CFC 000] O 1 2 3 4 5 6 7. 120 120 120 120 120 120 120 Total After Tax Dep. CESP Expense Expense 9000 1285.71 1405.711 1110.51|| 1285.71 1405.71 1110.51 1285.71 1405.71 1110.51 1285.71 1405.71| 1110.51] 1285.71 1405.71 1110.51 1285.71 1405.71 1110.51 1285.71 1405.71 1110.51 NPV PVAF Equated Annual Cost (EAC) 9000 -175.20 -175.200 -175.20 -175.20 -175.20 -175.20 -175.20 PVF @ 8.5% 1 0.922 0.849 0.783 0.722 0.665 0.613 0.565 Present Value 9000.00 -161.47 -148.82 -137.17 -126.42 -116.52 -107.39 -98.98 8103.24 5.1185 1583.12

where, Total Expense After Tax Expense CFSP Salvage cashflow = Salvage X (1 - Tax rate) CFC PVAF Expense + Dep. Total Expense X (1 - Tax Rate) Cashflow due to Drill After Tax Expense - Depreciation + CFSP (1+r)^n - 1 rX (1+r)^n [1/(1+r)]^n PVF where r is required rate of return and n is life of drill Present Value EAC CFC X PVAF Net Present Value PVAF Net Present Value Hence, Drill B must be chosen as it has lower EAC.