A company is deciding which of two alternative machines (X and Y) to purchase.
The useful lives for machines X and Y are two years and three years
respectively. The cash flows associated with each of the machines are given in
the table below:
Year 0 1 2 3
$000 $000 $000 $000
Machine X (200) 200 230
Machine Y (240) 200 230 240
Each of the machines would be replaced at the end of its useful life by an
identical machine. You should assume that the cash flows for the future
replacements of machines X and Y are the same as those in the table above.
The company’s cost of capital is 12% per annum.
Required:
(b) Calculate, using the annualised equivalent method, whether the company
should purchase machine X or machine Y.
(5 marks)
(c) Explain the limitations of using the annualised equivalent method when making
investment decisions.