Question

In: Finance

Samir heads a team to select from two different machines to replace an aging one. Their...

Samir heads a team to select from two different machines to replace an aging one. Their upfront costs, such as installation, are different. Also their useful lives are 4 years and 5 years respectively. Their salvage values, operating costs and net benefits are different. Nonetheless, they each have pros and cons to consider.

Tammy, a junior engineer, has suggested using the equivalent annual annuity (EAA) method to compare each machine’s financial attributes.

Describe how the EAA method works by creating an example using the two projects above. Show your work.

Solutions

Expert Solution

Let us make the following assumptions about the two machines :

Machine 1

Upfront cost = $10,000

Operating cost per year = $2,000

Useful life = 4 years

Net benefits per year = $6,000

Salvage value = $1,000

Machine 2

Upfront cost = $18,000

Operating cost per year = $3,500

Useful life = 5 years

Net benefits per year = $9,000

Salvage value = $1,500

For both machines, assume the discount rate is 10%.

For each machine :

Cash outflow in initial year = upfront cost

Cash inflow in each year (excluding final year) = net benefits - operating cost

Cash inflow in final year = net benefits - operating cost + salvage value

EAA = (NPV * r) / (1 - (1 + r)-n)

where NPV = net present value

r = discount rate

n = useful life

The NPV and EAA of each machine are calculated as below :

As the EAA of Machine 1 is higher, Machine 1 should be chosen.

The EAA method enables us to compare investments with unequal lives.


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