Your company needs a machine for the next seven years, and you have two choices

Question

Your company needs a machine for the next seven years, and you have two choices (assume an annual interest rate of 8%). Machine A costs $110,000 and has an annual operating cost of S49,000. Machine A has a useful life of seven years and a salvage value of $18,000. Machine B costs $160,000 and has an annual operating cost of $32,000. Machine B has a useful life of five years and no salvage value. However, the life of Machine B can be extended by two years with a certain amount of investment. If Machine B's life is extended, it will still cost $32,000 annually to operate and still have no salvage value. What would you pay at the end of year 5 to extend the life of Machine B by two years?

Explanation / Answer

This is a comparison of 2 machines.

The maximum I will pay to extend the life of Machine B will be such that the Present Value of Acsh Outflows from both the machines are equal.

Let x be the amount paid at Year end 5 to extend the life of Machine B

Hence, 110,000+49000*PVAF(8%,7yrs) - 18000*PVF(8%, 7yrs) = 160,000 + 32000*PVAF(8%, 7yrs)+ x*PVF(8%, 5 yrs)

110,000+49000*5.206- 18000*0.583 = 160,000+32000*5.206+x*0.681

354600 = 326592+0.681x

which means x = 41,128

Therefore, I will pay 41,128 at the end of 5 years tp extend the life of the machine.

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