Question

Brooks, Inc. 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 $485,000, annual operating costs of $28,500, and a 3-year life. Machine B costs $300,000, has annual operating costs of $45,400, and a 2-year life. The firm currently pays no taxes. Which machine should be purchased and why? Machine A; because it will save the company about $8,500 a year Machine A; because it will save the company about $7,318 a year Machine B; because it will save the company about $7,520 a year Machine B; because it will save the company about $8,216 a year Machine B; because it will save the company about $9,412 a year

Answer 1

Here, we need to calculate the equivalent annual cost of both the machines

Machine A:

Cost = $485000

Annual operating costs = $28500 and llife = 3 years

Required rate of return = 12%

Present value of annuity of $1 at 12 % for 3 years is 2.4018

Present value of the operating costs of the machine = $28500 * 2.4018

= $68451.3

Total present value of cash outflows = $485000 + $68451.3

= $553451.3

Equivalent annual cash outflow = Total Present value / PVIF

PVIF at 12% for 3 years is 2.4018

= $553451.3 / 2.4018

= $230431.88

Machine B:

Cost = $300000

Annual operating costs = $45400 and llife = 2 years

Required rate of return = 12%

Present value of annuity of $1 at 12 % for 2 years is 1.6901

Present value of the operating costs of the machine = $45400 * 1.6901

= $76730.54

Total present value of cash outflows = $300000 + $76730.54

= $376730.54

Equivalent annual cash outflow = Total Present value / PVIF

PVIF at 12% for 2 years is 1.6901

= $376730.54 / 1.6901

= $222904.28

We can see from the above calculation,that equivalent annual cost of Machine B is lower. So, Machine B should be purchased because it will save the company about $7520 ($22294.28 - $230431.88) a year.