Question

The Borstal Company has to choose between two machines that do the same job but have different lives. The two machines have the following costs:

Year	Machine A		Machine B
0	$47,000		$57,000
1	11,400		10,800
2	11,400		10,800
3	11,400	+ replace	10,800
4			10,800	+ replace

These costs are expressed in real terms.

1. Suppose you are Borstal’s financial manager. If you had to buy one or the other machine and rent it to the production manager for that machine’s economic life, what annual rental payment would you have to charge? Assume a 10% real discount rate and ignore taxes.

	Annual Rental Payment
Machine A	?
Machine B	?

2. Which machine should Borstal buy?

3. If there is steady 6% per year inflation, what will be the annual rental payment for machine B for the second year?

Answer 1

1)

Discount rate = 10%

Machine A:

Present value of all costs = 47,000 + (11,400 / 1.10) + (11,400 / 1.10^2) + (11,400 /1.10^3)

= 75,350

Equivalent annual cost = 75,350 / PVIFA(r = 10% ; n = 4)

= 75,350 / 2.49

= 30,299.40

Machine B:

Present value of all costs = 57,000 + (10800 / 1.10) + (10,800 / 1.10^2) + (10,800 /1.10^3) + (10,800 / 1.10^4)

= 91,234

Equivalent cost = 91,234 / PVIFA(r = 10% ; n = 4)

= 91,234 / 3.17

= 28,781.83

Machine A - 30,299.40

Machine B - 28,781.83

2)

Since annual cost of machine B is less borstal should buy Machine B

3)

cash flow in  year 2 for machine B = 28,781.83*(1+6%)^2 = $32,339.27