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?

		Machine A; because it will save the company about $25,216 a year
		Machine A; because it will save the company about $19,112 a year
		Machine B; because it will save the company about $20,741 a year
		Machine B; because it will save the company about $22,140 a year
		Machine A; because it will save the company about $23,570 a year

Answer 1

In the present situation, we have to calculate the annualized costs of each alternative and then compare them as the useful lives of each are different. The following tables show the calculations

PV Factors

= 1 / (1 + r) ^ n

Where,

r = Rate of interest = 13% or 0.13

So, PV Factor for year 2 will be

= 1 / (1.13^2)

= 1 / 1.2769

= 0.783147

	Machine A
Calculations	Years	0	1	2	3
A	Initial cost	-405000
B	Annual cost		-25000	-25000	-25000
C = A+B	Total costs	-405000	-25000	-25000	-25000
D	PV Factor	1	0.884956	0.783147	0.69305
E = C x D	Present Values	-405000	-22123.9	-19578.7	-17326.3
F = Sum E	Sum of Present Values	-464029
G = Sum D year 1 to 3	Sum of PV Factors	2.361153
H = F / G	Annual costs	-196526

	Machine B
Calculations	Years	0	1	2
A	Initial cost	-313000
B	Annual cost		-28000	-28000
C = A+B	Total costs	-313000	-28000	-28000
D	PV Factor	1	0.884956	0.783147
E = C x D	Present Values	-313000	-24778.8	-21928.1
F = Sum E	Sum of Present Values	-359707
G = Sum D year 1 to 2	Sum of PV Factors	1.668102
H = F / G	Annual costs	-215638

As we can find, cost per year of Machine A is $ 196,526 and that of Machine B is $ 215,638. So, annual savings by choosing Machine A

= $ 215,638 - $196,526

= $19,112

So, as per above discussion, option B is the correct option