Question

A company that manufactures magnetic flow meters expects to undertake a project that will have the cash flows below. At an interest rate of 10% per year, what is the equivalent annual cost of the project? Find the AW value using a spreadsheet.

First cost, $ -800,000
Equipment replacement cost, in year 2, $ -300,000
Annual operating cost, $/year -950,000
Salvage value, $ 250,000
Life, years 4

Answer 1

To find the equivalent annual cost, use the cash flows given, apply the present value method to discount them at the 10% interest rate, and then calculate the annual worth using the capital recovery factor.

Step-by-step explanation:

To calculate the equivalent annual cost (EAC) or the annual worth (AW) of the project, we'll need to consider all cash flows associated with the project, including the initial cost, the equipment replacement cost, the annual operating costs, and the salvage value at the end of the project's life, discounting them at the given interest rate of 10%.

This involves using the present value (PV) and annual equivalent value methods of capital budgeting. The formula for AW is AW = PV(A/P, i%, n), where A/P is the capital recovery factor, i is the interest rate, and n is the project lifespan in years.

Using a spreadsheet, we can compute the present value of each cash flow and then use the capital recovery factor to find the annual equivalent (AW). In the first year, there's an initial cost of $800,000, followed by an equipment replacement in the second year of $300,000.

The annual operating cost (which occurs for every year of the project's life) is $950,000, and at the end of the fourth year, the project also has a salvage value of $250,000.

These cash flows can be brought to present value using the formula PV = FV / (1+i)^n, and you would use the spreadsheet to sum these present values to obtain the total PV of the project. Next, you use the fact that AW = PV(A/P, i%, n) to find the annual worth, where A/P comes from standard financial tables or a financial calculator.