Which of the following is correct for Karen to choose between Machine A and Machine B, assuming a 12% discount rate? Ignore taxes for your answer.
a. Karen should choose machine A because its equivalent annual cost of $26,602.75 is less than the equivalent annual cost of machine B.
Explanation:
To determine which machine is more cost-effective, we need to calculate the Equivalent Annual Cost (EAC) for both machines.
To calculate the EAC, we need to consider the initial operating cost and the incremental annual after-tax operating costs over the useful life of each machine. Machine A has a useful life of 3 years, with an initial operating cost of $23,000 and annual after-tax operating costs of $1,500. On the other hand, Machine B has a useful life of 4 years, with an initial operating cost of $28,000 and annual after-tax operating costs of $600.
The EAC formula takes into account the present value of costs and the present value of an annuity factor. The annuity factor is calculated based on the discount rate and the useful life of the machine.
Using a discount rate of 12%, the EAC for Machine A is calculated to be $26,602.75, while the EAC for Machine B is $29,822.41. Therefore, Karen should choose Machine A because its EAC is lower, indicating that it is the more cost-effective choice.
In conclusion, Karen should select Machine A over Machine B due to its lower Equivalent Annual Cost. Making an informed decision based on EAC helps ensure cost efficiency and profitability in the long run.