We warned that equivalent annual costs should be calculated in real terms. We did not fully explain why. This problem will show you.
Look back to the cash flows for machines A and B (in “Choosing between Long- and Short-Lived Equipment”). The present values of purchase and operating costs are 28.37 (over three years for A) and 21.00 (over two years for B). The real discount rate is 6% and the inflation rate is 5%.
a. Calculate the three- and two-year level nominal annuities which have present values of 28.37 and 21.00. Explain why these annuities are not realistic estimates of equivalent annual costs. (Hint: In real life machinery rentals increase with inflation.)
b. Suppose the inflation rate increases to 25%. The real interest rate stays at 6%. Recalculate the level nominal annuities. Note that the ranking of machines A and B appears to change. Why?
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