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You are evaluating two different cookie-baking ovens. The Pillsbury 707 costs $57,500, has a...

Question:

You are evaluating two different cookie-baking ovens. The Pillsbury 707 costs $57,500, has a 5-year life, and has an annual OCF (after tax) of -$10,100 per year. The Keebler CookieMunster costs $90,500, has a 7-year life, and has an annual OCF (after tax) of -$8,100 per year. If your discount rate is 11%, what is each machine's EAC?

Equivalent Annual Cost:

The equivalent annual cost converts the costs of a project over its life into an annuity, thus providing a more straightforward assessment of the project's costs. The equivalent annual cost is particularly useful when comparing projects with different lengths.

Answer and Explanation:

We can use the following formula to compute the equivalent annual cost:

  • {eq}\displaystyle \frac{F*r}{1 - (1 + r)^{-T}} + C {/eq}

where {eq}F{/eq} is the initial cost, {eq}r{/eq} is discount rate, {eq}T{/eq} is the length of the project and {eq}C{/eq} is the annual cost.

For Philsbury 707, equivalent annual cost is:

  • {eq}\displaystyle \frac{57,500*11\%}{(1 - (1 + 11\%)^{-5})} + 10,100 = 25,657.79 {/eq}

For Keeble CookieMunster, equivalent annual cost is:

  • {eq}\displaystyle \frac{90,500*11\%}{(1 - (1 + 11\%)^{-7})} + 8,100 = 27,305.48 {/eq}

Learn more about this topic:

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How to Calculate the Present Value of an Annuity

from Business 110: Business Math

Chapter 8 / Lesson 3
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