Question

Problem 6 The Rocket Production Corp has a project with unequal economic lives and operating costs of two types of equipment. They have asked you to help them in resolving their capital budgeting dilemma. The project involves a standard model that costs $50,000 and will have a useful life of four years. Operating costs are expected to be $4,000 per year. The superior model costs $90,000 and will have a useful life of six years. Its operating costs are expected to be $2,500 per year. Both models will be able to operate at the same level of output and quality and generate the same cash earnings. The firm’s cost of capital is 10 percent.

a. Compute the present values of the cash costs over the useful life of each model.

b. Can the two present values be compared? If not, why not?

c. What is the annuity-equivalent cost of each model? (NPV/pvifannuity)) or NPV value spread each year

d. What model should the company purchase? Please explain your reason for selection.

Answer 1

a]	PV of costs of Standard model = -50000-4000*PVIFA(10,4) = -50000-4000*3.16987 =	$        (62,679.48)
	PV of costs of Superior model = -90000-2500*PVIFA(10,6) = -50000-4000*4.35526 =	$        (67,421.04)
b]	The two PVs cannot be compared as, the useful lives
	of the two alternatives are different, which means that
	the comparison of the PVs of cash flows would be
	Inequitable.
c]	EAC of standard model = 62679.48/3.16987 =	$           19,773.52
	EAC of superior model = 67421.04/4.35526 =	$           15,480.37
d]	The company should purchase the superior model as
	its EAC is lower.