Part A: Choosing between mutually exclusive projects

Suppose Kramerica Industries hired you are the manager in charge of selecting new equipment used for producing newly licensed smart widgets. Both machines produce smart widgets of equal product quality, and either machine selected would require regular replacement.

Annual Outlook:

Unit sales per year = 10,000 units

Price per unit initially = $22

Inflation of 3% per year (starting in year 2) applied to price per unit

Costs per year will keep up with inflation, so calculate total costs as 75% of sales

Tax Rate is 25%

WACC is 20%

NWC is fixed (either machine will require $25,000 up front to buy inventory)

Option 1: Machine FY would have the following costs and depreciation schedule:

Equipment Cost/Depreciation Basis is $60,000

Physical life of 6 years

For FY, you have the option of MACRS depreciation for 5-year asset life (20%, 32%, 19.2%, 11.52%, 11.52%, 5.76%), or straight-line depreciation (ignoring the half-year convention for straight-line) Calculate NPV using both methods

Option 2: Machine HS would have the following costs and depreciation schedule:

Equipment Cost/Depreciation Basis is $41,000

Physical life of 3 years

Considering the short physical life, you only consider straight-line depreciation so you can fully depreciate the asset.

Making the decision:

Use the EAA (Effective Annual Annuities) approach and the replacement chain approach to determine which machine you choose.

Part B: Convince the board of your selection

Once you have settled on a machine, calculate NPV, IRR, MIRR, Profitability Index, and Payback Period.

What issues could arise when selecting a machine using the EAA approach?