Question

Fishnet 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 13 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 $405,000, annual operating costs of $25,000, and a 3-year life. Machine B costs $313,000, has annual operating costs of $28,000, and a 2-year life. The firm currently pays no taxes. Which machine should be purchased and why?

Answer 1

Here, the both Machines have different useful lives and therefore, the decision can be made on the basis of Equivalent Annual Annuity (EAA)

MACHINE - A

Year	Annual Operating Costs ($)	Present Value Factor at 13%	Present Value of Annual Operating Costs ($)
1	-25,000	0.88496	-22,123.89
2	-25,000	0.78315	-19,578.67
3	-25,000	0.69305	-17,326.25
TOTAL		2.36115	-59,028.81

Net Present Value (NPV) = Present Value of annual cash inflows – Initial Investment

= -$59,028.81 - $405,000

= -$4,64,028.81 (Negative NPV)

Equivalent Annual Annuity (EAA) – MACHINE – A = Net Present Value / (PVIFA 13%, 3 Year)

= -$4,64,028.81 / 2.36115

= -$1,96,526.40

MACHINE - B

Year	Annual Operating Costs ($)	Present Value Factor at 13%	Present Value of Annual Operating Costs ($)
1	-28,000	0.88496	-24,778.76
2	-28,000	0.78315	-21,928.11
TOTAL		1.66810	-46,706.87

Net Present Value (NPV) = Present Value of annual cash inflows – Initial Investment

= -$46,706.87 - $313,000

= -$3,59,706.87 (Negative NPV)

Equivalent Annual Annuity (EAA) – MACHINE – B = Net Present Value / (PVIFA 13%, 2 Year)

= -$3,59,706.87 / 1.66810

= -$2,15,638.36

DECISION

The Fishnet should purchase “MACHINE A”, since the Equivalent Annual Annuity of MACHINE A (-$1,96,526.40) is less than the Equivalent Annual Annuity of MACHINE B (-$2,15,638.36)