Question

You can continue to use your less efficient machine with an initial investment of $1,000 and a maintenance cost of $7,980 annually for the next five years. Alternatively, you can purchase a more efficient new machine for $12,000 initial cost today, plus $5,000 annual maintenance with the same FIVE years life. At a cost of capital of 15%, you should:

• A. Keep the less efficient machine and save $600 in the equivalent annual annuity.

• B. Keep the less efficient machine and save $302 in the equivalent annual annuity.

• C. Keep the old machine and save $596 in the equivalent annual annuity.

• D. Buy the new machine and save $600 in the equivalent annual annuity.

• E. Buy the new machine and save $596 in the equivalent annual annuity.

Answer 1

A. Keep the less efficient machine and save $600 in the equivalent annual annuity.

	Less Efficient Machine		More efficient machine
Year	Cash flows
0	0		-12000
1	-7980		-5000
2	-7980		-5000
3	-7980		-5000
4	-7980		-5000
5	-7980		-5000
NPV	($26,750.20)		($28,760.78)
EAA	$7,980.00		$8,579.79
Difference	$599.79

Workings

The cash flows of the less efficient machine are $7980 each year from years 1 to 5. The initial cost is sunk cost and so not counted.

The cash flows of the more efficient machine will be the initial cost as well as annual maintenance costs.

Compute the NPV using the NPV function

Find an Equivalent annual annuity using PMT function in Excel.

The EAA of less efficient machine is lower by $600.