DeCento\'s is analyzing two machines to determine which one it should purchase.

Question

DeCento's is analyzing two machines to determine which one it should purchase. Whichever machine is purchased will be replaced at the end of its useful life. The company requires a 12 percent rate of return and uses straight-line depreciation to a zero book value over the life of the machine. Machine A has a cost of $276,000, annual operating costs of $18,000, and a 3-year life. Machine B costs $220,000, has annual operating costs of $22,000, and a 2-year life. The firm currently pays no taxes. Which machine should be purchased and why?

a. Machine A; because it will save the company about $18,600 a year b. Machine A; because it will save the company about $19,261 a year c. Machine B; because it will save the company about $21,202 a year d. Machine B; because it will save the company about $19,315 a year e. Machine B; because it will save the company about $18,667 a year

Explanation / Answer

Comparing unequal life assets where replacement is done at the end of life of asset Assumption: Lets say discount rate be 10% Calculation of Equivalent annual Cost of machine A Present value of cost of machine $ 276,000.00 Annual operating costs $    18,000.00 Life = 3 Years PVF (12%, 3 years )            2.40183 Present value of the operating costs = 18000*2.40183 $    43,232.94 Total Present value of cash out flows = 276000+ 43232.94 $ 319,232.94 PVF (12%, 3 years )            2.40183 Equivalent annual cash out flow = 320763.3 / 2.48685 $ 132,912.38 Calculation of Equivalent annual Cost of machine B Present value of cost of machine $ 220,000.00 Annual operating costs $    22,000.00 Life = 2 Years PVF (12%, 2 years )            1.69005 Present value of the operating costs = 22000*1.69005 $    37,181.10 Total Present value of cash out flows =220000+37181.10 $ 257,181.10 PVF (12%, 2 years )            1.69005 Equivalent annual cash out flow = 320763.3 / 2.48685 $ 152,173.66 Saving in Annual cost if machine A is used = (152173.66 - 132912.38) $    19,261.28 We can see that Equivalent annual cost of Machine A is lower than B , hence Machine A is better option as it will save the Co. about $19261 a year

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