Question

2. (a) A civil engineering contractor operates a fleet of mini-diggers, and from past experience has found that a mini-digger normally has a useful working life of 5 years. Such a machine has an initial capital cost of €10,000 and at the end of the 5-year period has a salvage value of €800. The cost of maintenance of each mini-digger amounts to €3,000 for the first year, and increases by €500 for each succeeding year.

(i) If the current interest rate is 12 per cent, which is the equivalent annual cost of owning and maintaining each mini-digger?

(ii) If the contractor can sell the mini-diggers for €1,200 each at the end of the fourth year, should he be advised to do so? (Provide calculations to justify your recommendation)

Answer 1

i]

Equivalent annual cost (EAC) = (NPV * r) / (1 - (1 + r)-n)

where NPV = net present value

r = discount rate

n = life of digger in years

NPV = sum of present values of cash flow digger's cash flows

present value of each cash flow = cash flow / (1 + discount rate)t

where t = number of years after which the cash flow occurs

The EAC is calculated as below :

EAC =  €6,535.47

EAC =  €6,535.47

b]

In this case, the EAC would change.

The EAC is calculated as below :

EAC =  €6,720.69

EAC =  €6,720.69

No, he should not be advised to do so because the EAC is higher if the digger is sold at the end of 4th year