Operating costs start at $80,000 increasing $5,000 per year
Interest Rate = 14%
Question: What is the equivalent annual cost of owning and operating the machine?
Jan 25th 2010, 04:38 AM
The two-step approach:
Determine the NPV of those CFs, using the given discount rate.
Determine the annual payment of a 5-year annuity which has the same PV. This amount is your "equivalent annual cost".
The rationale: By taking on the tractor, the company (farmer?) has obligated itself to the described cash flows. These are equivalent to an immediate cash outlay of 'X', which you determine in Step 1.
Instead of an immediate cash outlay of X, the company could opt to borrow X today, thereby swapping the immediate outlay for an obligation on a 5-year fully amortizing note. The annual payment on this note, as you determine in Step 2, is your equivalent annual cost.