ExpertMedium2 marksMultiple Choice
ACCA · Question 04 · Investment Appraisal
Section A
TerraFirma Mining needs to replace its heavy excavation machinery. The machinery can be replaced every 2 years or every 3 years. The cost of capital is 10%.
2-year cycle: PV of costs = $145,000
3-year cycle: PV of costs = $205,000
Annuity factors at 10%: 2 years = 1.736, 3 years = 2.487
Based on the Equivalent Annual Cost (EAC), which replacement cycle should be chosen and what is its EAC?
Section A
TerraFirma Mining needs to replace its heavy excavation machinery. The machinery can be replaced every 2 years or every 3 years. The cost of capital is 10%.
2-year cycle: PV of costs = $145,000
3-year cycle: PV of costs = $205,000
Annuity factors at 10%: 2 years = 1.736, 3 years = 2.487
Based on the Equivalent Annual Cost (EAC), which replacement cycle should be chosen and what is its EAC?
Answer options:
A.
2-year cycle with an EAC of $83,525
B.
3-year cycle with an EAC of $82,429
C.
2-year cycle with an EAC of $72,500
D.
3-year cycle with an EAC of $68,333
How to approach this question
Calculate the EAC for both options by dividing the PV of costs by the annuity factor for the respective years. Choose the option with the lowest EAC.
Full Answer
B.3-year cycle with an EAC of $82,429✓ Correct
To compare assets with different lifespans, we use the Equivalent Annual Cost (EAC) method.
EAC (2 years) = $145,000 / 1.736 = $83,525.
EAC (3 years) = $205,000 / 2.487 = $82,429.
Since TerraFirma wants to minimize costs, the 3-year cycle is optimal because its EAC is lower.
Common mistakes
Dividing the PV by the number of years instead of the annuity factor.
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