Question

Econo-cool air conditioners cost $300 to purchase, result in electricity bills of $150 per year, and last for 5 years. Luxury Air models cost $500, result in electricity bills of $100 per year, and last for 8 years. The discount rate is 21 percent.

a. What are the equivalent annual costs of the Econo-cool and Luxury Air models? Which model is more cost effective?
b. Now you remember that the inflation rate is expected to be 10 percent per year for the foreseeable future. How does the inflation rate affect the evaluation of the two air conditioners?

Answer 1

(a).Equivalent Annual Costs (EAC) of the Econo-Cool and Luxury Air models

Econo-Cool

$ 300 = EAC x Annuity factor(21%, 5 years)

$ 300 = EAC x 2.92598

EAC = $ 300 / 2.92598

EAC = $ 102.53

The equivalent annual cost of owning and running Econo-cool is: rental fee + electricity cost = $102.53 + $150 = $252.53

Luxury Air

$ 500 = EAC x Annuity factor(21%, 8 years)

$ 500 = EAC x 3.72558

EAC = $ 500 / 3.72558

EAC = $ 134.21

The equivalent annual cost of owning and running Luxury Air -cool is: rental fee + electricity cost = $ 134.21 + $ 100= $ 234.21

LUXURY AIR IS MORE COST-EFFECTIVE. IT HAS THE LOWER EQUIVALENT ANNUAL COST.

(b)Calculation of Equivalent Annual Cost at Inflation rate of 10%

Econo-Cool

$ 300 = EAC x Annuity factor(10%, 5 years)

$ 300 = EAC x 3.79079

EAC = $ 300 / 3.79079

EAC = $ 79.14

The equivalent annual cost of owning and running Econo-cool is: rental fee + electricity cost = $ 79.14 + $150 = $ 229.14

Luxury Air

$ 500 = EAC x Annuity factor(10%, 8 years)

$ 500 = EAC x 5.33493

EAC = $ 500 / 5.33493

EAC = $ 93.72

The equivalent annual cost of owning and running Luxury Air -cool is: rental fee + electricity cost = $ 93.72 + $ 100= $ 193.72