Chapter 6, Problem 37QAP

a.

Summary Introduction

Adequate information:

Cost of new computer = $580,000

Useful life of new computer = 5 years

Pre-tax salvage value of new computer = $130,000

Saving in operating cost of new computer = $85,000

Cost of old computer = $450,000

Depreciation on the old computer per year = 90,000

Sale value of old computer = $230,000

Pre-tax salvage value of old computer = $60,000

Discount rate, r = 14% or 0.14

Tax rate = 21% or 0.21

To compute: Whether to replace the old computer and invest in the new computer.

Introduction: Equivalent annual cost (EAC) refers to the yearly cost of maintaining and operating assets over their life. The equivalent annual cost is useful for the company when taking capital budgeting decisions. It is helpful in the comparison of alternatives that have an unequal useful life.

b.

Summary Introduction

Adequate information:

Cost of new computer = $580,000

Useful life of new computer = 5 years

Pre-tax salvage value of new computer = $130,000

Saving in operating cost of new computer = $85,000

Cost of old computer = $450,000

Depreciation on the old computer per year = 90,000

Sale value of old computer = $230,000

Pre-tax salvage value of old computer = $60,000

Discount rate, r = 14% or 0.14

Tax rate = 21% or 0.21

To compute:

• The relevant cash flows
• Whether to replace the old computer and invest in the new computer.

Introduction: Net present value is defined as the summation of the present value of cash inflows in each period minus the summation of the present value of cash outflow. The decision criteria of net present value are that in the case of a single project, if the net present value of the project is zero or positive, the project should be accepted, otherwise rejected. In the case of the mutually exclusive project, the project having the higher net present value should be selected.