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Comparing Mutually Exclusive Projects: Equivalent Annual Cost (EAC)

Question: Eads Industrial Systems Company (EISC) is trying to decide between two different conveyor belt systems. System A costs $456,000, has a 3-year life, and requires $150,000 in pretax annual operating costs. System B costs $521,000, has a 5-year life, and requires $83,000 in pretax annual operating costs. Both systems are to be depreciated straight-line to zero over their lives and will have zero salvage value. EISC always needs a conveyor belt system; when one wears out, it must be replaced. If the tax rate is 31 percent and the discount rate is 15 percent, the EAC for project A is $ ___ and the EAC for project B is $ ___ . Therefore, the firm should choose project A or B. (Negative amount should be indicated by a minus sign. Round answers to 2 decimal places, e.g. 32.16.)

Solution Preview

Please open the attachment file which has been provided as well. By clicking on the cells directly, you can see how the calculations have been computed.

PVIFA = Present Value Interest Factor for an Annuity
It can be read from tables or calculated using the following equation
PVIFA( n, r%)= =[1-1/(1+r%)^n]/r%

System A:
Tax rate = 31%

Cost = $456,000
Salvage value = $0
Life = 3 years
Therefore, annual depreciation = $152,000 = $456,000./3

Tax shield provided by depreciation =Tax ...

Solution Summary

The solution compares the equivalent annual cost (EAC) of two mutually exclusive projects (two different conveyor belt systems). All calculations have been included in this solution which is about 215 words. An Excel attachment file has been included which illustrates how the calculations have been computed.

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