# EAC with depreciation

Asked Jun 9, 2012, 07:01 PM — 1 Answer
You are evaluating two different silicon wafer milling machines. The Techron I costs \$200,000, has a 5-year life, and has pretax operating costs of \$39,000 per year. The Techron II costs \$314,000, has a 8-year life, and has pretax operating costs of \$20,000 per year. For both milling machines, use straight-line depreciation to zero over the project's life and assume a salvage value of \$20,000. If your tax rate is 31 percent and your discount rate is 11 percent. The Techron I has an EAC of \$ , while the Techron II has an EAC of \$ . You prefer Techron (Click to select)III. (Do not include the dollar signs (\$). Negative amounts should be indicated by a minus sign. Round your answer to 2 decimal places. (e.g., 32.16))

I have figured out the EAC without depreciation, but I am having trouble understanding where depreciation comes in.

I found 93114.0619 as the EAC by taking 200,000 + 39000/1.11 +39000/1.11^2 + 39000/1.11^3+39000/1.11^4+1.11^5 and then dividing that by (1-1/1.11^5)/.11

I also tried 200,000/((1-1/1.11^5)/.11) + 39000 = 93114.0619 or rounded 93114.06

 ArcSine Posts: 948, Reputation: 518 Senior Member #2 Jun 10, 2012, 05:09 AM
Depreciation will add two effects to your annual cash flow schedule.

First, depreciation is a deduction for tax purposes. So for example a machine costing 200K and depreciated linearly for 5 years will invoke a depreciation deduction of 40K per year, 5 years. With an effective tax rate of 31% this will produce tax savings of 40K x 0.31 = 12,400 per year. This 12,400 should be considered a cash inflow for each of the 5 years.

Second, by depreciating the asset to a zero carrying value, it means that when the asset is disposed of for its salvage value at the end of its useful life, the entire salvage value will represent a taxable gain. Hence upon the disposition of the asset you'll have the 20,000 proceeds coming in, but also a 20K x 0.31 = 6,200 tax bill to pay. This too should be considered in your cash flow schedule.

Add these depreciation-tax cash flow effects to your other cash flows from the machines, and you'll be ready to go back and figure your EACs.

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