Question

Capital Budgeting Exercise 1

You are considering the purchase of one of two machines used in your manufacturing plant. Machine A has a life of two years, costs $1500 initially, and then $400 per year in maintenance costs. Machine B costs $2000 initially, has a life of three years, and requires $300 in annual maintenance costs. Either machine must be replaced at the end of its life with an equivalent machine. Which is the better machine for the firm? The discount rate is 6% and the tax rate is zero.

Year	0	1	2	3
Machine A's Cash Flows
Machine B's Cash Flows

Machine A's EAC
Machine B's EAC

Which machine do you choose? Explain.

Answer 1

Calculation of Equivalent Annual cost.

EAC= Annual cost+(Initial investment+initial working capital)/Annuity factor

Annuity Formula	(1-(1+r)^(-n))/r
r=required return
n=number of periods

MAchine A

Annuity factor for project(2,6%)	1.83	(1-(1.06)^(-2))/0.06
Equivalent annual cost=	1,219.67	400+(1500/1.83)

Machine B

Annuity factor for project(3,6%)	2.67	(1-(1.06)^(-3))/0.06
Equivalent annual cost=	1,049.06	300+(2000/2.67)

So choose Machine B since its EAC is lowest.