You are a financial consultant that helps companies evaluate capital budgeting decisions. Your client, Johnson-Hammes, is a company that modifies trucks for specialized applications. Johnson-Hammes can bid on a contract to customize and deliver 24 trucks over 5 years to a customer. They have hired you to assist them in making various capital budgeting decisions. Johnson-Hammes' required rate of return for such projects is 20% and its marginal tax rate is 21%.

In order to fulfil the contract, Johnson-Hammes will have to purchase certain equipment. It is considering two different options.

1. Option 1 has a purchase price of $125,000 and will cost $10,000 per year to operate. It needs to be replaced every 6 years. At the end of its useful life, it has a salvage value of $5,000.
2. Option 2 has a purchase price of $140,000 and will cost $8,500 per year to operate. It needs to be replaced every 8 years. At the end of its useful life, it has a salvage value of $7,000.
3. It costs $5,000 to install either option.
4. The equipment Johnson-Hammes plans to purchase qualifies for 5-year MACRS depreciation.

 

Which option should Johnson-Hammes purchase? Justify your decision based on comparison of the equivalent annual cost for each option. Assume that Johnson-Hammes will continue to replace the option you recommend on an ongoing basis.

Answer rating: 100% (QA)

To determine which equipment option JohnsonHammes should purchase we need to calculate the equivalent annual cost EAC for both options The EAC allows ... View the full answer