Chapter 7: Net Present Value and Capital Budgeting

PROBLEM # 7.6:
Year 0
1. Keyboards Produced
2. Price per Keyboard
3. Sales revenue [1*2]
4. Cost per Keyboard
5. Operating costs[1*4]
6. Gross Margin [3-5]
7. Depreciation
8. Pretax Income [6-7]
9. Taxes at 34%
10. Net income [8-9]
11. Cash flow from
operations [10+7]
12. Investment
13. Total Cash Flow

-400,000
-$400,000

Year 1
10,000
40
400,000
20
200,000
200,000
80,000
120,000
40,800
79,200
159,200

Year 2
10,000
40(1.05)
420,000
20(1.10)
220,000
200,000
80,000
120,000
40,800
79,200
159,200

Year 3
10,000
40(1.05)2
441,000
20(1.10)2
242,000
199,000
80,000
119,000
40,460
78,540
158,540

Year 4
10,000
40(1.05)3
463,050
20(1.10)3
266,200
196,850
80,000
116,850
39,729
77,121
157,121

Year 5
10,000
40(1.05)4
486,203
20(1.10)4
292,820
193,383
80,000
113,383
38,549
74,834
154,834

$159,200

$159,200

$158,540

$157,121

$154,834

Since the initial investment occurs today (year 0), its present value does not need to be adjusted.
PV(C0)
PV(C1)
PV(C2)
PV(C3)
PV(C4)
PV(C5)

= -$400,000
= $159,200 / (1.15) = $138,435
= $159,200 / (1.15)2 = $120,378
= $158,540 / (1.15)3 = $104,243
= $157,121 / (1.15)4 = $89,834
= $154,834 / (1.15)5 = $76,980

NPV

= PV(C0) + PV(C1) + PV(C2) + PV(C3) + PV(C4) + PV(C5) = $129,870

These calculations could also have been performed in a single step:

NPV

= -$400,000+ $159,200 / (1.15) + $159,200 / (1.15)2 + $158,540 / (1.15)3

+ $157,121 / (1.15)4 + $154,834 / (1.15)5
= $129,870

The NPV of the investment is $129,870.

PROBLEM # 7.8:
t=0
1. Revenues
2. Expenses
3. Depreciation
4. Pretax Income
[1-2-3]
5. Taxes (35%)
6. Net Income [4-5]
7. Net Working Capital
8. CF from Operations
[6+3+7]
9. Capital Investment
10. Tax benefit from
Capital Loss*
11. A/T-NCF

- 25,000
- 25,000

t = 1- 2
$600,000
150,000
150,000
$300,000

t=3
$600,000
150,000
150,000
$300,000

105,000
$195,000

105,000
$195,000
$25,000
$370,000

$345,000

- $750,000

$40,000
$91,000

- $775,000

$345,000

B-134

$501,000

* The capital loss arises because the resale value ($40,000) is less than the net book value ($300,000). The
tax benefit from the capital loss is computed by multiplying the amount of the capital loss by the tax rate
($91,000 = 0.35 * $260,000). This represents the tax shield, i.e. the reduction in taxes from the capital loss.
The cash flows in years 1 and 2 could also have been computed using the following simplification:
After-Tax NCF

= Revenue (1 Tc) - Expenses (1 Tc) + Depreciation (Tc)

= $600,000 (0.65) - $150,000 (0.65) + $150,000(0.35)
= $345,000

PV(C0)
PV(C1)
PV(C2)
PV(C3)

= -$775,000
= $345,000/ (1.17) = $294,872
= $345,000/ (1.17)2 = $252,027
= $501,000/(1.17)3 = $312,810

NPV

= PV(C0) + PV(C1) + PV(C2) + PV(C3) = $84,709

These calculations could also have been performed in a single step:

NPV

= -$775,000 + $345,000/ (1.17) + $345,000/ (1.17)2 + $501,000/(1.17)3

= -$775,000 + $294,872 + $252,027 + $312,810
= $84,709

The NPV of the new software is $84,709.

PROBLEM # 7.16:
Year
0
Investments:
Touch screen
system
Annual
maintenance
Change in NWC
Wages saved
Total cash flow
from investments
Income:
Revenue
COGS
Cash flow from
operations
Total cash flow
from project
PV
15% (CF)

Year
1

Year
2

Year
3

Year
4

Year
5

NPV

$
(150,000)

$
(150,000)

$
(150,000)
= CF
(150,000)

B-131

$ (5,000)

$ (5,000)

$ (5,000)

$ (5,000)

$ (5,000)

$ (5,000)
$30,000
$20,000

$30,000
$25,000

$30,000
$25,000

$30,000
$25,000

$ 5,000
$30,000
$30,000

$15,000
$ (3,750)
$11,250

$15,000
$ (3,750)
$11,250

$15,000
$ (3,750)
$11,250

$15,000
$ (3,750)
$11,250

$15,000
$ (3,750)
$11,250

$31,250

$36,250

$36,250

$36,250

$41,250

= CF/
(1.15)2
27,410

= CF/
(1.15)3
23,835

= CF/
(1.15)4
20,726

= CF/
(1.15)5
20,509

= CF/1.15
27,174

No, the big burrito should not make this investment because it has a negative NPV.

B-135

($30,346)

PROBLEM # 7.21:
7.21 Nominal cash flows should be discounted at the nominal discount rate. Real cash flows should be discounted
at the real discount rate. Project As cash flows are presented in real terms. Therefore, one must compute the
real discount rate before calculating the NPV of Project A. Since the cash flows of Project B are given in
nominal terms, discount its cash flows by the nominal rate in order to calculate its NPV.
Nominal Discount Rate
Inflation Rate
1 + Real Discount Rate
Real Discount Rate

= 0.15
= 0.04
= (1+ Nominal Discount Rate) / (1+ Inflation Rate)
= 0.1058 =10.58%

Project As cash flows are expressed in real terms and therefore should be discounted at the real discount
rate of 10.58%.
Project A:
PV(C0) = -$40,000
PV(C1) = $20,000 / (1.1058) = $18,086
PV(C2) = $15,000/ (1.1058)2 = $12,267
PV(C3) = $15,000 / (1.1058)3 = $11,093
NPVA

= PV(C0) + PV(C1) + PV(C2) + PV(C3)

= $1,446

These calculations could also have been performed in a single step:

NPVA

= -$40,000+ $20,000 / (1.1058) + $15,000 / (1.1058)2 + $15,000 / (1.1058)3

= $1,446

Project Bs cash flows are expressed in nominal terms and therefore should be discounted at the nominal
discount rate of 15%.
Project B:
PV(C0) = -$50,000
PV(C1) = $10,000 / (1.15) = $8,696
PV(C2) = $20,000/ (1.15)2 = $15,123
PV(C3) = $40,000 / (1.15)3 = $26,301
NPVB

= PV(C0) + PV(C1) + PV(C2) + PV(C3)

= $120

These calculations could also have been performed in a single step:

NPVB

= -$50,000+ $10,000 / (1.15) + $20,000 / (1.15)2 + $40,000 / (1.15)3

= $120

Since the NPV of Project A is greater than the NPV of Project B, choose Project A.

B-136

PROBLEM # 7.23:
Since the problem lists nominal cash flows and a real discount rate, one must determine the nominal discount rate
before computing the net present value of the project.
1 + Real Discount Rate
1.14
Nominal Discount Rate
1.
2.
3.
4.
5.
6.
7.
8.
10.

11.

Sales revenue
Operating costs
Depreciation
Income before
tax
[1-2-3]
Taxes at 34%
Net income
[4-5]
Cash flow from
operation
[1-2-5]
Initial
Investment
Total cash flow
from
investment
[9+10]
Total cash flow
[7+10]

= (1 + Nominal Discount Rate) / (1 + Inflation Rate)

= (1+ Nominal Discount Rate) / (1.05)
= 0.197

Year 0
-

Year 1
$50,000
20,000
17,143
12,857

Year 2
$52,500
21,400
17,143
13,957

Year 3
$55,125
22,898
17,143
15,084

Year 4
$57,881
24,501
17,143
16,237

Year 5
$60,775
26,216
17,143
17,416

Year 6
$63,814
28,051
17,143
18,620

Year 7
$67,005
30,015
17,143
19,847

4,371
8,486

4,745
9,212

5,129
9,955

5,521
10,716

5,921
11,495

6,331
12,289

6,748
13,099

25,629

26,355

27,098

27,859

28,638

29,432

30,242

-120,000

-120,000

-120,000

25,629

26,355

27,098

27,859

28,638

29,432

30,242

PV(C0)
PV(C1)
PV(C2)
PV(C3)
PV(C4)
PV(C5)
PV(C6)
PV(C7)

= -$120,000
= $25,629 / (1.197) = $21,411
= $26,355 / (1.197)2 = $18,394
= $27,098 / (1.197)3 = $15,800
= $27,859 / (1.197)4 = $13,570
= $28,638 / (1.197)5 = $11,654
= $29,432 / (1.197)6 = $10,006
= $30,242 / (1.197)7 = $8,589

NPV

= PV(C0) + PV(C1) + PV(C2) + PV(C3) + PV(C4) + PV(C5) + PV(C6) + PV(C7)

= -$20,576

These calculations could also have been performed in a single step:

NPV

= -$120,000 + $25,629 / (1.197) + $26,025 / (1.197)2 + $27,098 / (1.197)3

+ $27,859 / (1.197)4 + $28,638 / (1.197)5 + $29,432 / (1.197)6
+ $30,242 / (1.197)7
= -$20,576

To solve the problem using a string of annuities, find the present value of each cash flow.
The investment occurs today and therefore is not discounted:
PV(Investment) = -$120,000
B-137

The PV of the revenues is found by using the growing annuity formula. Note that nominal cash flows must
be discounted by nominal rates. The following solution treats revenues as a growing annuity discounted at
19.7 percent and growing at five percent annually over seven years:
PV(Revenues)
PV(Revenues)

= C1 (1 Tc) GATr, g
= $50,000 GA70.197, 0.05 (1 - 0.34)*
= $134,775

* The notation GATr, g represents a growing annuity consisting of T payments growing at a rate of g per
payment, discounted at r.
The PV of the expenses is found using the same method that was used in finding the PV of the revenues.
Again, the expenses are treated as a nominal growing annuity, discounted at 19.7 percent and growing at
seven percent annually over seven years:
PV Expenses
PV Expenses

= C1 GATr, g (1 Tc)
= $20,000 GA70.197, 0.07 (1 - 0.34)
= $56,534

Since the firm has positive net income, the firm will benefit from the depreciation tax shield. Apply the
annuity formula to the string of annual tax shields to find the present value of the taxes saved.
PV(Depreciation Tax Shield)
PV(Depreciation Tax Shield)

= Tc (Annual Depreciation) ATr

= 0.34 ($120,000 / 7) A70.197
= $21,183

The present value of the project is the sum of the previous annuities:
PV Project
PV Project
PV Project

= -Investment + Revenue - Expenses + Depreciation Tax Shield

= -$120,000 + $134,775 - $56,534 + $21,183
= -$20,576

Since the project has a negative NPV, -$20,576, it should be rejected.

The nominal cash flow during year 5 is $157,926.
PROBLEM # 7.26:
Year 1
Year 2
Year 3
Year 4
Revenues
$40,000,000 $80,000,000 $80,000,000 $60,000,000
Labor Costs
30,600,000 31,212,000 31,836,240 32,472,965
Energy Costs
1,030,000 1,060,900 1,092,727 1,125,509
Revenues-Costs
8,370,000 47,727,100 47,071,033 26,401,526
After-tax Revenues-Costs 5,524,200 31,499,886 31,066,882 17,425,007
Since revenues and costs are expressed in real terms, after-tax income will be discounted at the real
discount rate of 8%.
Remember that the depreciation tax shield also affects a firms after-tax cash flows. The present value of
the depreciation tax shield must be added to the present value of a firms revenues and expenses to find the
present value of the cash flows related to the project. The depreciation the firm will recognize each year is:
Depreciation

= Investment / Economic Life

B-138

= $32,000,000 / 4
= $8,000,000
Next, find the annual depreciation tax shield. Remember that this reduction in taxes is equal to the tax rate
times the depreciation expense for the year.
Annual Depreciation Tax Shield

= Tc (Annual Depreciation Expense)

= 0.34 ($8,000,000)
= $2,720,000

Remember that depreciation is a nominal quantity, and thus must be discounted at the nominal rate. To find
the nominal rate, use the following equation:
1+ Real Discount Rate
1.08
Nominal Discount Rate

= (1+Nominal Discount Rate) / (1+Inflation Rate)

= (1+Nominal Discount Rate) / (1.05)
= 0.134

To find the present value of the depreciation tax shield, apply the four-year annuity formula to the annual
tax savings:
PV(Tax Shield) = C1 A40.134
= $2,720,000 A40.134
= $8,023,779
PV(C0) = -$32,000,000
PV(C1) = $5,524,200 / (1.08)
PV(C2) = $31,499,886 / (1.08)2
PV(C3) = $31,066,882 / (1.08)3
PV(C4) = $17,425,007 / (1.08)4
PV(Depreciation Tax Shield)
NPV

= -$32,000,000
= $5,115,000
= $27,006,075
= $24,661,893
= $12,807,900
= $8,023,779

= PV(C0) + PV(C1) + PV(C2) + PV(C3) + PV(C4) + PV(Depreciation Tax Shield)

= $45,614,647

These calculations also could have been performed in a single step:

NPV

= -$32,000,000+ $5,524,200 / (1.08) + $31,499,886 / (1.08)2 + $31,066,882 / (1.08)3

+ $17,425,007 / (1.08)4 + (0.34) ($8,000,000) A40.134
= $45,614,647

The NPV of the project is $45,614,647.

PROBLEM # 7.29:
7.29

Since the problem asks which medicine the company should produce, solve for the NPV of both medicines
and select the one with the higher NPV.
Headache-only medicine:
First, find the PV of the initial investment. Since the cash outlay occurs today, no discounting is necessary.
PV(Initial Investment) = -$10,200,000
Find the PV of the revenues if the headache-only medicine were produced. The problem states that the
selling price will be $4 in real terms. Since the discount rate, 0.13, is also given in real terms, no

B-139

adjustment is necessary and inflation can be ignored. The problem also indicates that 5 million packages
will be sold in each of the next three years. The PV will be expressed as a three-year annuity discounted at
0.13. Remember to find the after-tax revenues by multiplying pre-tax revenues by (1 - Tc).
Annual Revenues Headache-only

= $4 * 5,000,000
= $20,000,000

PV(Headache-only revenues)

= (1 - Tc) C1 ATr,
= (1 - 0.34) $20,000,000 A30.13
= $31,167,214

Annual costs per unit will be $1.50 in real terms. The PV will be expressed as a three-year annuity
discounted at the real discount rate of 0.13. Remember to find the after-tax costs by multiplying pre-tax
costs by (1 - Tc).
Annual Costs Headache-only

= -$1.50 * 5,000,000
= -$7,500,000

PV(Headache-only costs)

= (1 - Tc) C1 ATr,
= (1 - 0.34)( -$7,500,000 A30.13)
= -$11,687,705

Since Pill, Inc. has positive pre-tax income, the firm will benefit from a depreciation tax shield.
Remember, depreciation is a nominal quantity and therefore must be discounted at the nominal rate.
1 + Real Rate
1.13
Nominal Rate

= (1 + Nominal Rate) / (1 + Inflation Rate)

= (1 + Nominal Rate) / (1.05)
= 0.1865

Annual depreciation, calculated by the straight-line method (Initial Investment / Economic Life of
Investment), is $3,400,000 (= $10,200,000 / 3 Years). The string of annual tax shields forms an annuity.
The present value of this annuity is:
PV(Depreciation Tax Shield)
PV(Depreciation Tax Shield)

= Tc (Annual Depreciation Expense) ATr

= 0.34 ($3,400,000) A30.1865
= $2,487,521

Since the resale value of the headache-only equipment is $0, it has no effect the NPV of the project. To
find the NPV of the project, find the sum of the present values of the initial investment, after-tax revenues,
after-tax costs, and the depreciation tax shield.
NPV = - Initial Investment + PV(Revenues) PV(Costs) + Depreciation Tax Shield
= -$10,200,000 + $31,167,214 $11,687,705 + $2,487,521
= $11,767,030
These calculations could also have been performed in a single step:
NPV = -$10,200,000 + (1 - 0.34) $20,000,000 A30.13 (1 - 0.34) $7,500,000 A30.13 +
0.34 ($3,400,000) A30.1865
= $11,767,030
Headache and Arthritis medicine:
First, find the PV of the initial investment. Since the cash outlay occurs today, no discounting is necessary.
PV(Initial Investment) = -$12,000,000

B-140

Find the PV of the revenues if the headache and arthritis medicine were produced. The problem states that
the selling price will be $4 in real terms. Since the discount rate, 0.13, is also given in real terms, no
adjustment is necessary, and inflation can be ignored. The problem also indicates that 10 million packages
will be sold in each of the next 3 years. The PV will be expressed as a three-year annuity discounted at
0.13. Remember to find the after-tax revenues by multiplying pre-tax revenues by (1 - Tc).
Annual Revenues Headache and Arthritis

= $4 * 10,000,000
= $40,000,000

PV(Headache and Arthritis revenues)

= (1 - Tc) C1 ATr,
= (1 - 0.34) $40,000,000 A30.13
= $62,334,429

The annual costs will be calculated using the same method. The problem states that annual costs per unit
will be $1.70. Again, since the costs and discount rate are given in real terms, inflation can be ignored.
The PV will be expressed as a three-year annuity discounted at 0.13. Remember to find the after-tax costs
by multiplying pre-tax costs by (1 - Tc).
Annual Costs Headache and Arthritis

= -$1.70 * 10,000,000
= -$17,000,000

PV(Headache and arthritis costs)

= (1 - Tc) C1 ATr,
= (1 - 0.34) -$17,000,000 A30.13
= -$26,492,132

Since Pill, Inc. has positive income, it will benefit from a depreciation tax shield. Remember, depreciation
is a nominal quantity and therefore must be discounted using the nominal rate.
1 + Real Discount Rate
1.13
Nominal Discount Rate

= (1 + Nominal Discount Rate) / (1 + Inflation Rate)

= (1 + Nominal Discount Rate) / (1.05)
= 0.1865

Annual depreciation, calculated by the straight-line method (Initial Investment / Economic Life of
Investment), is $4,000,000 (= $12,000,000 / 3 Years). The string of annual tax shields forms an annuity.
The present value of this annuity is:
PV(Depreciation Tax Shield)
PV(Depreciation Tax Shield)

= Tc (Annual Depreciation) ATr

= 0.34 ($4,000,000) A30.1865
= $2,926,496

Unlike the Headache-only medicine equipment, the Headache and Arthritis medicine equipment has a
resale value of $1 million at the end of three years. Since the net book value of the equipment is $0, Pill,
Inc. must pay capital gains taxes on the total $1 million resale value. Because the resale value is stated in
real terms, it is discounted using the real discount rate.
After-Tax Salvage Value = Salvage Value Tc (Salvage Value Book Value)
= $1,000,000 0.34 ($1,000,000 $0)
= $660,000
The salvage value must then be discounted in order to find the PV.
PV(Salvage Value)

= C3 / (1 + r)3
= $660,000 / (1.13)3
= $457,413

B-141

To find the NPV of the project, find the sum of the present values of the initial investment, after-tax
revenues, after-tax costs, the depreciation tax shield, and the resale.
NPV = - Initial Investment + PV(Revenues) PV(Costs) + PV(Tax Shield) + PV(Resale Value)
= -$12,000,000 + $62,334,429 $26,492,132 + $2,926,496 + $457,413
= $27,226,206
These calculations could also have been performed in a single step:
NPV = -$12,000,000 + (1 - 0.34) $40,000,000 A30.13 (1 - 0.34) $17,000,000 A30.13
+ 0.34 ($4,000,000) A30.1865 + [$1,000,000 0.34 ($1,000,000 $0)] / (1.13)3
= $27,226,206
Pill, Inc. should produce the Headache and Arthritis medicine since it has the higher NPV.
PROBLEM # 7.36:
7.36

Find the net present value (NPV) of each option. The firm will choose the option with the higher NPV.
Remember to take into account both the maintenance costs and depreciation tax shields associated with
both the old and new machines. Note that the replacement machine will be bought in five years regardless
of the option chosen and therefore is not incremental to this decision.
Option 1
Sell old machine and purchase new machine now.
To find the cash flow from selling the old machine, consider both the sales price and the net book value of
the machine. Since the firm will be selling the old machine ($2,000,000) for more than its net book value
($1,000,000), the resultant capital gain will be subject to corporate taxes.
After-Tax Salvage Value

= Sale Price TC(Sale Price Net Book Value)

= $2,000,000 0.34($2,000,000 - $1,000,000)
= $1,660,000

PV(Salvage Value)

= $1,660,000

The new machine is purchased today (year 0) and does not need to be discounted.
PV(New Machine) = -$3,000,000
To find the present value of the new machines maintenance costs, use a five-year annuity, discounted at 12
percent. Remember to account for taxes.
PV(Maintenance Costs)

= (1 0.34)(-$500,000)A50.12
= -$1,189,576

The firm will also recognize a depreciation tax shield from the new machine. The annual depreciation
expense is $600,000 (= $3,000,000 / 5 years).
Annual Depreciation Tax Shield

= TC * Depreciation per year

= 0.34 * $600,000
= $204,000

The present value of the depreciation tax shields can be found by using a five-year annuity, discounted at
12 percent.

B-142

PV(Depreciation Tax Shield)

= C1 ATr
= $204,000 A50.12
= $735,374

The new machine will be sold at the end of its economic life. Since the resale price ($500,000) is higher
than the net book value ($0), the sale of the machine is subject to capital gains taxes. Since the sale occurs
at the end of year 5, discount the after-tax salvage value back 5 periods.
After-Tax Salvage Value = Sale Price TC(Sale Price Net Book Value)
= $500,000 0.34($500,000 0)
= $330,000
PV(Salvage Value)

NPV(Option 1)

= $330,000 / (1.12)5
= $187,251

= $1,660,000 - $3,000,000 - $1,189,576 + $735,374 + $187,251

= -$1,606,950

The net present value (NPV) of selling the old machine and purchasing the new machine now is
-$1,606,950.
Option 2
Sell old machine in five years and purchase new machine in five years.
The company will have to make the scheduled maintenance costs for the old machine. Use a five-year
annuity, discounted at 12 percent to find the present value of the costs. Remember to account for taxes.
PV(Maintenance Costs)

= (1 0.34)(-$400,000)A50.12
= -$951,661

The firm will continue to recognize depreciation on the old machine. The annual depreciation expense is
$200,000 per year, and the firm will recognize a depreciation tax shield. The present value of the tax shield
is found by using a five-year annuity, discounted at 12 percent.
Annual Depreciation Tax Shield

= 0.34 * $200,000
= $68,000

PV(Depreciation Tax Shield)

= $68,000 A50.12
= $245,125

The salvage value at the end of the old machines economic life of five years will be $200,000. Since the
machine will have been depreciated to $0, the firm must pay capital gains taxes on the sale. To find the
present value, discount the after-tax salvage value by five periods.
After-Tax Salvage Value = Sale Price TC(Sale Price Net Book Value)
= $200,000 0.34($200,000 0)
= $132,000
PV(Salvage Value)

= $132,000 / (1.12)5
= $74,900

NPV(Option 2)

= -$951,661 + $245,125 + $74,900

= -631,636

B-143

The net present value (NPV) of selling the old machine and purchasing the new machine in five years
is -631,636.
Since the NPV of Option 2 is higher than the NPV of Option 1, the firm will choose to sell the old
equipment and purchase new equipment in five years.
PROBLEM # 7.37:
7.37

SAL 5000
The first step is to find the NPV of the costs associated with the SAL 5000. Find the NPV of one SAL
5000, and later, when finding the equivalent annual cost (EAC) of the decision, multiply the final answer
by 10. The initial investment is not discounted because it occurs today (year 0).
PV(Initial Investment) = -$3,750
Each year, the computer requires $500 of maintenance. Apply the eight-year annuity formula, discounted
at 11 percent, to find the PV of the cost.
PV(Maintenance Costs)

= C1 ATr
= -$500 A80.11
= -$2,573

At the end of the computers economic life, it will have a resale value of $500. Since there are no capital
gains taxes, the PV is just that cash flow, discounted by eight periods.
PV(Salvage Value)

= C8 / (1 + r)8
= $500 / (1.11)8
= $217

The NPV of the computer is the combination of the above cash flows.
NPV = -Initial Investment PV(Maintenance Costs) + PV(Salvage Value)
= -$3,750 - $2,573+ $217
= -$6,106
In order to calculate the equivalent annual cost, set the NPV of the computer equal to an annuity with the
same economic life. Since the computer has an economic life of eight years, set the NPV equal to an eightyear annuity, discounted at 11 percent.
-$6,106 = EAC * A80.11
EAC
= -$1,187
Since Gold Star Industries would have to buy 10 SAL 5000s, the EAC here would be:
Total EAC

= (Number of SAL 5000s purchased) (EAC of one SAL 5000)

= (10) (-$1,187)
= -$11,870

The equivalent annual cost (EAC) for the decision to buy the SAL 5000 is $11,870.
DET 1000
The first step is to find the NPV of the costs associated with the DET 1000. Find the NPV of one DET
1000, and later, when finding the equivalent annual cost (EAC) of the decision, multiply the final answer
by 8. The initial investment is not discounted because it occurs today (year 0).

B-144

PV(Initial Investment) = -$5,250

Each year, the computer requires $700 of maintenance. Apply the six-year annuity formula, discounted at
11 percent, to find the PV of the cost.
PV(Maintenance Costs)

= C1 ATr
= -$700 A60.11
= -$2,961

At the end of the computers economic life, it will have a resale value of $600. Since there are no capital
gains taxes, the PV is just that cash flow, discounted by six periods.
PV (Salvage Value)

= C6 / (1 + r)6
= $600 / (1.11)6
= $321

The NPV of the computer is the combination of the above cash flows.
NPV = -Initial Investment PV(Maintenance) + PV(Salvage)
= -$5,250 - $2,961+ $321
= -$7,890
In order to calculate the equivalent annual cost, set the NPV of the computer equal to an annuity with the
same economic life. Since the computer has an economic life of six years, set the NPV equal to a six-year
annuity, discounted at 11 percent.
-$7,890 = EAC * A60.11
EAC
= -$1,865
Since Gold Star Industries would have to buy eight DET 1000s, the EAC here would be:
Total EAC

= (Number of DET 1000s purchased) (EAC of one DET 1000)

= (8) (-$1,865)
= -$14,920

The equivalent annual cost for the decision to buy the DET 1000 is $14,920.
Gold Star should purchase the SAL 5000 since it has a lower equivalent annual cost (EAC).

B-145