question archive Q5- Mega Printers Incorporated is evaluating some new technology options
Q5- Mega Printers Incorporated is evaluating some new technology options
Subject:FinancePrice:2.86 Bought7
Q5- Mega Printers Incorporated is evaluating some new technology options. Option A costs $16 million initially, has an annual operating cost of $320,000, and a life of 10 years before it is replaced. Option B costs $14 million initially, has an annual operating cost of $450,000, and a life of 8 years before it is replaced. What is the equivalent annual cost for each machine, if the required return is 11%? Ignore taxes. The VP of operations is emphatic that the decision should be made based on the annual operating costs, only, saying that present value calculations will complicate this relatively simple decision unecessarily, and should be avoided. According to the VP, Option A is the best choice. Which option should the company purchase? Discuss."
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Equivalent Annual Cost = Net Present Value / PVAF (11%, project life)
NPV of Option A = $ 16 million + $ 3,20,000 * PVAF (11%, 10 years) i.e. $ 16 million + $ 3,20,000 * 5.8892 = $ 17,884,544
Equivalent Annual Cost of Option A = $ 17,884,544 / 5.8892 = $ 3,036,838 (cost)
NPV of Option B = $ 14 million + $ 4,50,000 * PVAF (11%, 8 years) i.e. $ 14 million + $ 4,50,000 * 5.1461 = $ 16,315,745
Equivalent Annual Cost of Option B = $ 16,315,745 / 5.1461 = $ 3,170,506 (cost)
Since the EAC of Option A is lower, it should be selected.
Selection of best Option on the basis of solely annual operating costs is not a logical approach. Selecting the best option on such a criteria ignores the initial costs of the projects which may differ by a significant amount. Also, it ignores the difference in lives of the projects.
