FINA 301 Capital Budgeting Exercises Capital Budgeting Exercise 1 You are consid

Question

FINA 301 Capital Budgeting Exercises 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 S1500 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 Machine A's Cash Flows 0 Machine A's EAC Machine B's EAC Which machine do you choose? Explain.

Explanation / Answer

Answer - Present value (PV) factor of 6% at the end of year 0 = 1, at the end of year 1 = 0.943, at the end of year 2 = 0.890, at the end of year 3 = 0.840 [ 1/(1.06)0 , 1/(1.06)1 , 1/(1.06)2 , 1/(1.06)3 ]

Intial cost of machine A is $1,500 & maintenance cost per year for 2 years is $400.

so, present value (PV) of initial investment at the end of year 0 = $1,500 X 1 = $1,500

PV of annual maintenance cost for 2 years = $400 X 1.833 = $733.200 [0.943 + 0.890 =1.833]

PV of total cost of using Machine A for 2 years = $1,500 + $733.200 = $2,233.200

Equalized annual cost (EAC) of Machine A = $2,233.200/1.833 = $1,218.331

Intial cost of machine B is $2,000 & maintenance cost per year for 3 years is $300.

so, present value (PV) of initial investment at the end of year 0 = $2,000 X 1 = $2,000

PV of annual maintenance cost for 3 years = $300 X 2.684 = $805.200 [0.943 + 0.890 + 0.840 =2.684]

PV of total cost of using Machine B for 3 years = $2,000 + $805.200 = $2,805.200

Equalized annual cost (EAC) of Machine B = $2,805.200/2.684 = $1,045.156

So, to answer the above questions -

So, by comapairing the EAC's of machine A & B, we can choose Machine B as it's EAC is lower than Machine A. By choosing Machine B plant's annual cash outflow will get minimised.   

Year 0 1 2 3 Machine A's cash flows -1,500 -400 -400 NIL Machine B's cash flows -2,000 -300 -300 -300

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