bre44380_ch06_132-161.indd 157 09/30/15 12:46 PM
Chapter 6 Making Investment Decisions with the Net Present Value Rule 157
- Equivalent annual costs Low-energy lightbulbs typically cost $3.60, have a life of nine
years, and use about $2.00 of electricity a year. Conventional lightbulbs are cheaper to buy,
for they cost only $.60. On the other hand, they last only about a year and use about $7.00 of
energ y.^15 If the real discount rate is 4%, which product is cheaper to use? - Replacement decisions Hayden Inc. has a number of copiers that were bought four years
ago for $20,000. Currently maintenance costs $2,000 a year, but the maintenance agreement
expires at the end of two years and thereafter the annual maintenance charge will rise to
$8,000. The machines have a current resale value of $8,000, but at the end of year 2 their
value will have fallen to $3,500. By the end of year 6 the machines will be valueless and
would be scrapped.
Hayden is considering replacing the copiers with new machines that would do essentially
the same job. These machines cost $25,000, and the company can take out an eight-year
maintenance contract for $1,000 a year. The machines will have no value by the end of the
eight years and will be scrapped.
Both machines are depreciated by using seven-year MACRS, and the tax rate is 35%.
Assume for simplicity that the inflation rate is zero. The real cost of capital is 7%. When
should Hayden replace its copiers? - Equivalent annual costs In the early 1990s, the California Air Resources Board (CARB)
started planning its “Phase 2” requirements for reformulated gasoline (RFG). RFG is gaso-
line blended to tight specifications designed to reduce pollution from motor vehicles. CARB
consulted with refiners, environmentalists, and other interested parties to design these speci-
fications. As the outline for the Phase 2 requirements emerged, refiners realized that substan-
tial capital investments would be required to upgrade California refineries.
Assume a refiner is contemplating an investment of $400 million to upgrade its Califor-
nian plant. The investment lasts for 25 years and does not change raw-material and operating
costs. The real (inflation-adjusted) cost of capital is 7%. How much extra revenue would be
needed each year to recover that cost? - Equivalent annual costs Look at the last question where you calculated the equivalent
annual cost of producing reformulated gasoline in California. Capital investment was $400
million. Suppose this amount can be depreciated for tax purposes on the 10-year MACRS
schedule from Table 6.4. The marginal tax rate, including California taxes, is 39%, the cost of
capital is 7%, and there is no inflation. The refinery improvements have an economic life of
25 years.
a. Calculate the after-tax equivalent annual cost. (Hint: It’s easiest to use the PV of deprecia-
tion tax shields as an offset to the initial investment).
b. How much extra would retail gasoline customers have to pay to cover this equivalent
annual cost? (Note: Extra income from higher retail prices would be taxed.)
- Equivalent annual costs The Borstal Company has to choose between two machines that
do the same job but have different lives. The two machines have the following costs:
(^15) Source: http://www.energystar.gov
Year Machine A Machine B
0 $40,000 $50,000
1 10,000 8,000
2 10,000 8,000
3 10,000 + replace 8,000
4 8,000 + replace