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Homework answers / question archive / The Tempo Golf and Country Club in London, Ontario, is evaluating two different irrigation system options

The Tempo Golf and Country Club in London, Ontario, is evaluating two different irrigation system options

Finance

The Tempo Golf and Country Club in London, Ontario, is evaluating two different irrigation system options. An underground automatic irrigation system will cost $9.2 million to install and $80,600 pre-tax annually to operate. It will not have to be replaced for 20 years. An aboveground system will cost $6.8 million to install, but $196,000 per year to operate. The aboveground equipment has an effective operating life of nine years. The country club leases its land from the city and both systems are considered leasehold improvements; as a result, straight-line capital cost allowance is used throughout, and neither system has any salvage value. The tax rate is 39%.

 

Calculate the equivalent annual cost for each method if we use a 13% discount rate? (Enter the answers in dollars. Do not round your intermediate calculations. Round the final answers to 2 decimal places. Negative answers should be indicated by a minus sign. Omit $ sign in your response.) 

 

MethodEACUnderground system$ Aboveground system$ 

 

Which method should we select?

 

 

multiple choice

  • Aboveground system
  • Underground system

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Answer

The  ground system has lower annual equivalent cost, hence it should be selected.

Explanation

Computation of Annual equivalent cost of the underground system:

Annual operating cost of underground system = $80,600

Annual post tax operating cost of underground system = $80,600*(1-0.39) = $49,166

Annual depreciation of underground system = $9,200,000/20 years = $460,000

Tax savings on depreciation = $460,000*0.39 = $179,400

Annual free cashflow for underground system = -$49,166 + $179,400 = $130,234

Present value of annual free cash flows = $130,234*(1-1.13-20)/0.13 = $914,861.50

Net present value of the underground system = -$9,200,000 + $914,861.50 = -$8,285,138.50

Annual equivalent cost of the underground system = $8,285,138.50/7.02475 = $1,179,420.85

 

Computation of Annual equivalent cost of the aboveground system

Annual operating cost of aboveground system = $196,000

Annual post tax operating cost of aboveground system = $196,000*(1-0.39) = $119,560

Annual depreciation of aboveground system = $6,800,000/9 years = $755,555.56

Tax savings on depreciation = $755,555.56*0.39 = $294,666.67

Annual free cash flow for aboveground system = -$119,560 + $294,666.67 = $175,106.67

Present value of annual free cash flows = $175,106.67*(1-1.13-9)/0.13  = $898,587.04

Net present value of the aboveground system = -$6,800,000 + $898,587.04 = -$5,901,412.96

Annual equivalent cost of the aboveground system = $5,901,412.96/5.13166 = $1,150,000.77

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