Question

1. P Authority is considering two manufacturers for the company’s bus needs. The buses are expected to generate the same annual revenue regardless of the manufacturer. The company will depreciate the buses straight-line over 5 years and stick with the manufacturer it chooses indefinitely.

Zonda will supply the buses for $150 million. The before-tax maintenance costs are expected to be $25 million every year. P Authority will have to replace these buses every 9 years.

MAN will supply the buses for $250 million. Before-tax maintenance costs are expected to be $15 million every year. P Authority will have to replace these buses every 14 years.

P Authority uses an annual discount rate of 14% and is in 20% marginal tax bracket. Using the equivalent annual cost analysis, determine the manufacturer P Authority should choose. Please show all work .

Answer 1

Equivalent annual cost (EAC) = (NPV * r) / (1 - (1 + r)-n)

where NPV = net present value

r = discount rate

n = life of asset in years

NPV = sum of present values of net cash flows

present value of each cash flow = cash flow / (1 + discount rate)number of years

net cash flow in year 0 = -(initial cost)

net cash flow in subsequent years = -((maintenance costs) * (1 - tax rate)) + (depreciation * tax rate)

depreciation in each year = initial cost / depreciable life

Zonda EAC = -$46,991,924

MAN EAC = -$50,080,858

P Authority should choose Zonda as the EAC is lower