Question

Capital Budgeting Exercise 1

You are considering the purchase of one of two machines used in your manufacturing plant. Machine A has a life of two years, costs $1500 initially, and then $400 per year in maintenance costs. Machine B costs $2000 initially, has a life of three years, and requires $300 in annual maintenance costs. Either machine must be replaced at the end of its life with an equivalent machine. Which is the better machine for the firm? The discount rate is 6% and the tax rate is zero.

Year	0	1	2	3
Machine A's Cash Flows
Machine B's Cash Flows

Machine A's EAC
Machine B's EAC

Which machine do you choose? Explain.

Answer 1

Solution :

The EAC of Machine A = - $ 1,218.16

The EAC of Machine B = - $ 1,048.22

Thus Machine B with lower EAC of - $ 1,048.22 is the better machine for the firm.

Thus the Machine B, which has a lower EAC is to be chosen.

Cash Flows of the Machine A & Machine B:

Year	0	1	2	3
Machine A's Cash Flows	-$ 1,500	-$ 400	-$ 400	$ 0
Machine B's Cash Flows	-$ 2,000	-$ 300	-$ 300	-$ 300

Discounted Cash Flows of the Machine A & Machine B:

Year	0	1	2	3
Machine A	-$ 1,500	-$ 377.36	-$ 356.00	0
Machine B	-$ 2,000	-$ 283.02	-$ 267.00	-$ 251.89

EAC of the Machines A & B

Machine A's EAC	- $ 1,218.16
Machine B's EAC	- $ 1,048.22

Please find the screenshot of the excel sheet containing the detailed calculation for the above solution.