ExpertMedium2 marksMultiple Choice
ACCA · Question 10 · Investment Appraisal
Section A
LogisticsPlus is deciding whether to replace its delivery trucks every 2 years or every 3 years. The cost of capital is 10%.
- A 2-year replacement cycle has a Present Value (PV) of total costs of $45,000.
- A 3-year replacement cycle has a PV of total costs of $60,000.
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 why?
Section A
LogisticsPlus is deciding whether to replace its delivery trucks every 2 years or every 3 years. The cost of capital is 10%.
- A 2-year replacement cycle has a Present Value (PV) of total costs of $45,000.
- A 3-year replacement cycle has a PV of total costs of $60,000.
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 why?
Answer options:
A.
The 2-year cycle, because its PV of costs ($45,000) is lower than the 3-year cycle.
B.
The 2-year cycle, because its EAC is $25,922, which is lower than the 3-year cycle's EAC.
C.
The 3-year cycle, because its EAC is $24,125, which is lower than the 2-year cycle's EAC.
D.
The 3-year cycle, because it delays the capital expenditure for an extra year.
How to approach this question
Calculate the EAC for both options by dividing the PV of costs by the respective annuity factor. Choose the option with the lowest EAC.
Full Answer
C.The 3-year cycle, because its EAC is $24,125, which is lower than the 2-year cycle's EAC.✓ Correct
To compare assets with unequal lives, we use Equivalent Annual Cost (EAC).
EAC (2 years) = $45,000 / 1.736 = $25,921.66
EAC (3 years) = $60,000 / 2.487 = $24,125.45
The 3-year cycle has a lower annualized cost, so it is the optimal replacement cycle.
Common mistakes
Comparing the Present Values directly without converting them to an annualized equivalent.
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