You are considering the purchase of one of two machines used in your manufacturing plant. Machine A has a life of two years, costs $100 initially, and then $150 per year in maintenance costs. Machine B costs $200 initially, has a life of three years, and requires $120 in annual maintenance costs. Either machine must be replaced at the end of its life with an equivalent machine. Using EAC which is the better machine for the firm? The discount rate is 12 percent and tax can be ignored.
A) Machine A
B) Machine B
C) All of these choices are correct.
D) Neither machine A nor B

Question

Quizplus · Accepted Answer

To determine the better machine using the Equivalent Annual Cost (EAC) method, we calculate the EAC for both machines. The EAC is the annual cost of owning and operating an asset over its entire lifespan. It includes both the initial purchase cost and the present value of maintenance costs, all converted into an equivalent annual amount.For Machine A:- Initial cost = $100- Annual maintenance cost = $150 for 2 years- Life = 2 yearsThe present value of maintenance costs = $150 / (1+0.12) + $150 / (1+0.12)^2 = $133.93 + $119.58 = $253.51Total cost = Initial cost + Present value of maintenance costs = $100 + $253.51 = $353.51EAC for Machine A = $353.51 / Annuity factor for 2 years at 12% = $353.51 / 1.6901 = $209.21For Machine B:- Initial cost = $200- Annual maintenance cost = $120 for 3 years- Life = 3 yearsThe present value of maintenance costs = $120 / (1+0.12) + $120 / (1+0.12)^2 + $120 / (1+0.12)^3 = $107.14 + $95.67 + $85.42 = $288.23Total cost = Initial cost + Present value of maintenance costs = $200 + $288.23 = $488.23EAC for Machine B = $488.23 / Annuity factor for 3 years at 12% = $488.23 / 2.4018 = $203.25Since the EAC for Machine B ($203.25) is lower than the EAC for Machine A ($209.21), Machine B is the better choice for the firm.

You Are Considering the Purchase of One of Two Machines