You are considering the purchase of one of two machines used in your manufacturing plant. Machine A has a life of two years, costs $20,000 initially, and then $4,000 per year in maintenance costs. Machine B costs $25,000 initially, has a life of three years, and requires $3,500 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 14 percent and the tax rate is zero.

Question

Quizplus · Accepted Answer

To determine which machine is the better choice, we need to calculate the present value of all costs over the respective lifetimes of each machine and choose the option with the lower total present value.

For Machine A, the initial cost is $20,000 and there are $4,000 maintenance costs per year for 2 years, so the total present value of costs is:

PV = $20,000 + $4,000/(1+0.14)^1 + $4,000/(1+0.14)^2 
PV = $20,000 + $3,508.77 + $3,076.73 
PV = $26,585.50

For Machine B, the initial cost is $25,000 and there are $3,500 maintenance costs per year for 3 years, so the total present value of costs is:

PV = $25,000 + $3,500/(1+0.14)^1 + $3,500/(1+0.14)^2 + $3,500/(1+0.14)^3 
PV = $25,000 + $3,070.18 + $2,680.64 + $2,341.12 
PV = $33,092.94

Therefore, the total present value of costs for Machine A is $26,585.50 and for Machine B is $33,092.94. Machine A is the better choice for the firm as it has the lower total present value of costs.

You Are Considering the Purchase of One of Two Machines