Vandalay Industries is considering the purchase of a new machine for the product

Question

Vandalay Industries is considering the purchase of a new machine for the production of latex. Machine A costs $2,010,000 and will last for 6 years. Variable costs are 37 percent of sales, and fixed costs are $131,000 per year. Machine B costs $4,370,000 and will last for 9 years. Variable costs for this machine are 31 percent of sales and fixed costs are $120,000 per year. The sales for each machine will be $8,740,000 per year. The required return is 10 percent and the tax rate is 35 percent. Both machines will be depreciated on a straight-line basis. If the company plans to replace the machine when it wears out on a perpetual basis, the EAC for machine A is $??? and the EAC for machine B is $???.

Explanation / Answer

The manager calculates the NPV of the machines: Machine A EAC=$85,400/=$31,360 Machine B EAC=$198,474/=$30,708 Note: To get the numerators add the present value of the annual maintenance to the purchase price. For example, for Machine A: 50,000 + 13,000/1.05 + 13,000/(1.05)^2 + 13,000/(1.05)^3 = 85,402. The result is the same, although the first method is easier it is essential that the annual maintenance cost is the same each year. Alternatively the manager can use the NPV method under the assumption that the machines will be replaced with the same cost of investment each time. This is known as the chain method since 8 repetitions of machine A are chained together and 3 repetitions of machine B are chained together. Since the time horizon used in the NPV comparison must be set to 24 years (3*8=24) in order to compare projects of equal length, this method can be slightly more complicated than calculating the EAC. In addition, the assumption of the same cost of investment for each link in the chain is essentially an assumption of zero inflation, so a real interest rate rather than a nominal interest rate is commonly used in the calculations.

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