The Philadelphia Pretzel Company is considering the purchase of a new pretzel tw

Question

The Philadelphia Pretzel Company is considering the purchase of a new pretzel twister.  The revenues are expected to be the same no matter which machine is acquired. The Knot-Me machine has a cost of $100,000 and is expected to last 5 years with operating costs of $15,000 per year. The Doughboy machine has a cost of $80,000 and operating costs of $18,000 per year but will last for only 4 years. The discount rate is 8%.  Ignore taxes and compute the equivalent annual cost (EAC) of each machine to the nearest dollar.  Which one should be chosen, and why?

Explanation / Answer

The Philadelphia Pretzel Company is considering the purchase of a new pretzel twister. The revenues are expected to be the same no matter which machine is acquired. The Knot-Me machine has a cost of $100,000 and is expected to last 5 years with operating costs of $15,000 per year. The Doughboy machine has a cost of $80,000 and operating costs of $18,000 per year but will last for only 4 years. The discount rate is 8%. Ignore taxes and compute the equivalent annual cost (EAC) of each machine to the nearest dollar. Which one should be chosen, and why?

Present Value of Cost of Knot-Me machine = 100000 + 15000*PVIFA(8%,5)

Present Value of cost of Knot-Me machine = 100000 + 15000* 3.9927

Present Value of cost of Knot-Me machine= $ 159,890.50

Present Value of Cost of Doughboy machine = 80000 + 18000*PVIFA(8%,4)

Present Value of cost of Doughboy machine= 80000 + 18000* 3.3121

Present Value of cost of Doughboy machine= $ 139,617.80

Equivalent annual cost of Knot-Me machine = Present Value of cost of Knot-Me machine/PVIFA(8%,5)

Equivalent annual cost of Knot-Me machine = $ 159890.50/3.9927

Equivalent annual cost of Knot-Me machine = $ 40,046

Equivalent annual cost of Doughboy machine= Present Value of cost of  Doughboy machine/PVIFA(8%,4)

Equivalent annual cost of Doughboy machine = $ 139617.80/3.3121

Equivalent annual cost of Doughboy machine = $ 42,154

Knot-Me-Machine should be choosen because Equivalent annual cost of Knot-Me machine is lower than Equivalent annual cost of Doughboy machine , hence it is profitable to choose Equivalent annual cost of Knot-Me machine

Note:

*PVIFA(8%,5) = 1/1.08 + 1/1.08^2 + 1/1.08^3 + 1/1.08^4 + 1/1.08^5

PVIFA(8%,5) = 3.9927

PVIFA(8%,4) = 1/1.08 + 1/1.08^2 + 1/1.08^3 + 1/1.08^4

PVIFA(8%,4) = 3.3121

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