Question

Suppose you operate a movie theater and are considering installing an arcade machine inside. The manufacturer offers you the regular model costing $10,000 or a deluxe model costing $13,000. The regular model has an expected economic life of fifteen years and the deluxe model has an expected economic life of twenty years. Assuming the operating characteristics of the machines both meet your needs and have identical maintenance costs, which model should you choose to install in your movie theater from a financial point of view? Assume a 7% cost of capital.

Answer 1

Equivalent annual cost, is a method of capital budgeting which is used to select a project out of 2 projects where the life of the assets is not same. Here we find the equal annual expense on the assets and select the project with lowest annual expenses.

We use the financial calculator to find the equal annual expense by using the PMT function.

For Regular Model

PV = 10000

IY = 7

N = 15 years

FV = Nil

Compute PMT we get = -1097.95

For Deluxe Model

PV = 13000

IY = 7

N = 20 years

FV = Nil

Compute PMT we get = -1227.11

Hence we observe that equal annual expense of regular model is lower, hence the same should be selected.