(b) Calculation of equivalent annual cost for machine 1
Since taxation and capital allowances are to be ignored, and where relevant all information relating to project 2 has already been adjusted to include future inflation, the correct discount rate to use here is the nominal before-tax weighted average cost of capital of 12%.
Present value of cash flows $236,535
Cumulative present value factor 2·402
Equivalent annual cost = 236,535/2·402 = $98,474
The machine with the lowest equivalent annual cost should be purchased and calculation shows this to be Machine 1. If the present value of future cash flows had been considered alone, Machine 2 (cost of $236,535) would have been preferred to Machine 1 (cost of $274,582). However, the lives of the two machines are different and the equivalent annual cost method allows this to be taken into consideration.
