In: Finance
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.
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.