Casa Chica is considering replacing a piece of equipment. Alternative A costs $80,000, has an eight year life and would produce net cash flows of $18,000 in each of the eight years. Alternative B costs $65,000, has a six year life and would produce net cash flows of $18,000 in each of the six years. If Chica's cost of capital is 13%, which alternative should be chosen using the equivalent annual annuity method?

Question

Quizplus · Accepted Answer

To find the equivalent annual annuity (EAA), we need to calculate the annuity amount that has the same present value as the cost of the project. We can use the formula: 
EAA = (Cost of Project * Discount Rate) / (1 - (1 + Discount Rate)^(-Number of Years))

For project A: 
EAA = (80,000 * 0.13) / (1 - (1 + 0.13)^(-8)) = $16,715.40

For project B: 
EAA = (65,000 * 0.13) / (1 - (1 + 0.13)^(-6)) = $17,461.96

Since the EAA of project B is higher than that of project A, project B should be chosen.

Casa Chica Is Considering Replacing a Piece of Equipment