Question

Gateway Tours is choosing between two bus models. One is more expensive to purchase and maintain but lasts much longer than the other.​ Gateway's discount rate is

11.5%.

The company plans to continue with one of the two models for the foreseeable future. Based on the costs of each shown​ below, which should it​ choose? ​ (Note: dollar amounts are in​ thousands.)

Model	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5	Year 6	Year 7
Old Reliable	−$199	−$3.9	−$3.9	−$3.9	−$3.9	−$3.9	−$3.9	−$3.9
Short and Sweet	−$98	−$2.1	−$2.1	−$2.1	−$2.1

Based on the costs of each​ model, which should it​ choose?  ​(Select the best choice​ below.)

A.

Gateway Tours should choose Short and Sweet because the NPV of its costs is smaller.

B.

Gateway Tours should choose Old Reliable because the equivalent annual annuity of its costs is smaller.

C.

Gateway Tours should choose Short and Sweet because the equivalent annual annuity of its costs is smaller.

D.

Gateway Tours should choose Old Reliable because it lasts longer.

Answer 1

C.

Gateway Tours should choose Short and Sweet because the equivalent annual annuity of its costs is smaller.

The NPV method is not suitable since the projects have different useful lives.

Hence first compute NPV using NPV function in Excel. Convert to Equivalent costs using PMT function.

The EAC of Short and Sweet is smaller which implies that it has lower annual costs than the other project. Selecting a project on the basis of its length, is irrelevant to decision making.

Workings

Model	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5	Year 6	Year 7	NPV	Equivalent annual cost
Old Reliable	-199	-3.9	-3.9	-3.9	-3.9	-3.9	-3.9	-3.9	-$217.08	-$46.82
Short and Sweet	-98	-2.1	-2.1	-2.1	-2.1				-$104.45	-$34.03