Question

You are trying to choose between purchasing one of two machines for a factory. Machine A costs $15,500 to purchase and has a three-year life. Machine B costs $17,400 to purchase but has a four-year life. Regardless of which machine you purchase, it will have to be replaced at the end of its operating life. Which machine should you choose? Assume a marginal tax rate of 35 percent and a discount rate of 15 percent. (Round answers to 2 decimal places, e.g. 15.25.)

Equivalent Annual Cost (EAC) of machine A
Equivalent Annual Cost (EAC) of machine B

Choose Machine BMachine A .

Answer 1

Calculation of EAC

EAC = Net Present value of Cash Outflows / PVAF @ r% for n years

Calculation of EAC of Machine A

Net Present value = -Initial Investment + Present value of Operating cash Flows

Annual Operating Cash Flows =Tax shield on Depreciation

= [(15500 / 3 ) * 0.35]

= [ 5166.67 * 0.35)

= 1808.333

Present value of Operating Cash Flows = Annual Operating Cash Flows * PVAF@15% for 3 years

= 1808.33 * 2.2832251171

= 4128.832

Net Present value = -15500 + 4128.832 = - 11371.1679133

EAC = -362620.4835732 / PVAF @ 15% for 3 years

= -11371.1679133 / 2.2832251171

=-$4980.31

Calculation of EAC of Machine B

Net Present value = -Initial Investment + Present value of Operating cash Flows

Annual Operating Cash Flows =Tax shield on Depreciation

= [(17400 / 4 ) * 0.35]

= [4350 * .35]

=1522.5

Present value of Operating Cash Flows = Annual Operating Cash Flows * PVAF@15% for 4 years

= 1522.5 * 2.85497836268

= 4346.70455718

Net Present value = -17400 + 4346.70455718 = -13053.2954429

EAC = -13053.2954429 / PVAF @ 15% for 4 years

= -13053.2954429 / 2.85497836268

=-$4572.12

Choose Machine B as it has lower EAC.