Chapter 6, Problem 26PS

Mutually exclusive investments and project lives The Borstal Company has to choose between two machines that do the same job but have different lives. The two machines have the following costs:

These costs are expressed in real terms.

1. a. Suppose you are Borstal’s financial manager. If you had to buy one or the other machine and rent it to the production manager for that machine’s economic life, what annual rental payment would you have to charge? Assume a 6% real discount rate and ignore taxes.
2. b. Which machine should Borstal buy?
3. c. Usually the rental payments you derived in part (a) are just hypothetical—a way of calculating and interpreting equivalent annual cost. Suppose you actually do buy one of the machines and rent it to the production manager. How much would you actually have to charge in each future year if there is steady 8% per year inflation? [Note: The rental payments calculated in part (a) are real cash flows. You would have to mark up those payments to cover inflation.]