The requirement here was to calculate the equivalent annual cost (EAC) of each of two machines and discuss which machine should be purchased. Very few answers gained few marks.

Weaker answers attempted to calculate the NPV of a conventional investment project, with a series of cash inflow following an initial investment. This of course was not possible, since the majority of cash flows were costs: only scrap value was a cash inflow.

Once the amount and the timing of the cash flows had been determined, the correct discount rate had to be selected. The question stated that taxation and capital allowances had to be ignored, and that all information relating to the two projects had already been adjusted for the effects of taxation, i.e. the cash flows relating to the two machines were nominal cash flows. The correct approach, therefore, was to discount nominal before-tax cash flows with the nominal before-tax weighted average cost of capital of 12%. Answers that inflated the cash flows or answers that used the nominal after-tax weighted average cost of capital were not correct.

To calculate the EAC, the present value (PV) of costs had to be divided by the annuity factor for 12% corresponding to the life of the machine. Weaker answers divided the PV of costs by the number of years or by the initial investment, demonstrating a lack of understanding of the investment appraisal technique being used.

Where the correct approach was used, answers approached the required discussion with an EAC for each machine.

Most answers stated that machine 1 should be bought as it gave lowest EAC. While this was correct and earned a mark, better answers explained that this recommendation could be made because the EAC approach had taken account of the different operating lives of the two machines. Simply comparing the PV of costs, which some answers did, would have incorrectly led to a recommendation of machine 2.