Question

You are evaluating two different computer servers for the business you work for. Server X costs $450,000, has a three-year life and costs $50 000 per year to operate. Server B costs $650,000, has a five-year life, and costs $40,000 per year to operate. The relevant discount rate is 8 per cent and corresponds with the 8% before–tax cost of debt. Ignoring depreciation and taxes, compute the Annual Equivalent Cost (AEC) for both servers. Which one would be preferred?

Answer 1

Annual Equivalent Cost (AEC) = Net Present Value / Present value annuity factor A(t,r)

A(t,r) = (1 - (1 / (1 + r) ^ t)) / r)

Where r is cost of capital; and t is number of years.

The A(t,r) of each server is as under:

Server X A(t,r) = (1 - (1 / (1 + 8%) ^ 3)) / 8%) = 2.58

Server B A(t,r) = (1 - (1 / (1 + 8%) ^ 5)) / 8%) = 3.99

Now, for calculating Annual Equivalent Cost the initial costs must be divided by the A(t,r) and the annual maintenance cost added in.

AEC Sever X = ($450000/2.58) + 50,000 = $224,419

AEC Server B = ($650000/3.99) + 40000 = $202,907

Since, AEC of Server B is less than AEC of Server X, Server B would be preferred.