When to replace an asset: Burt's Pizzas is considering whether to purchase an oven. Burt's calculates that its current oven generates $4,000 of cash flow per year. A new oven would cost $15,000 and would provide cash flow of $6,000 per year for six years. What is the equivalent annual cash flow for the new oven (round to the nearest dollar), and should Burt's purchase the new oven? Assume the cost of capital for Burt's is 12 percent.

Question

Quizplus · Accepted Answer

The equivalent annual cash flow (EAC) for the new oven can be calculated using the formula for the annuity payment given the present value (PV), the interest rate (r), and the number of periods (n). The present value here is the cost of the new oven, -$15,000. The interest rate is 12%, and the number of periods is 6 years. Using the formula $EAC = PV \times \frac{r(1+r)^n}{(1+r)^n-1}$, we find the EAC to be approximately $2,352 (rounded to the nearest dollar). Since the EAC of the new oven ($2,352) is less than the cash flow generated by the current oven ($4,000), Burt's should not purchase the new oven.

When to Replace an Asset: Burt's Pizzas Is Considering Whether