equivalent annual cost and sensitivity analysis, Corporate Finance

Mad Cat Inc. is debating between two alternative earth moving machines to use for the next 8 years.  The first supplier, Double Candle, offers the necessary machinery (CCA rate = 30%) at an upfront cost of $5,450,000.  These machines are expected to last 4 years and then be salvaged for approximately $1,400,000 (the CCA pool remains open).   All the Double Candle machines would be salvaged and replaced after 4 years.  The alternative is to purchase significantly more expensive (but longer lasting) machinery from Elemental which would last the full 8 years but cost $8,650,000 and depreciate at the same CCA rate.  Elemental's machines have an expected salvage value of approximately $1,800,000.  Mad Cat pays a 25% tax rate and its cost of capital is 11%.

a)  Which of the two systems incurs the lowest overall cost for Mad Cat? 

b)  Making projections about cash flows in the future can be quite a difficult task for junior analysts.  For what salvage value on the Elemental machines would you be indifferent between the two options?

c)  At what price for the Elemental machines would you be indifferent between the two options (assuming $1,000,000 in salvage regardless of the purchase price).

d) How would you feel about your original decision in part a) if Element instead offered to let you finance the purchase for $1,450,000 per year for 8 years with each payment made at the beginning of each year.  The arrangement would enable Mad Cat to depreciate the asset as though it was owned the entire time, and to salvage it at the end of its useful life (a financial lease - the payments are not tax deductible).


Posted Date: 2/23/2013 3:12:47 AM | Location : United States

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