Problem 2: Investment Decision Rules (20 Marks)

James is trying to figure out the optimal number of years to replace his machinery. The machinery will be replaced continously for the foreseeable future. The machinery costs

$35,000. The maintenance costs for each respective year are shown in the table below together with the salvage value of the machinery if it were to be sold in that year. James has decided to keep the machinery for at least 4 years but is uncertain whether a 4 or 5 year replacement period is most appropriate. The discount rate is 10% per annum and assume zero taxes.

Year	0	1	2	3	4	5
Initial cost	-35,000
Maintenance costs		-2,100	-3,200	-4,300	-5,400	-6,500
Salvage value (if sold)		32,000	28,000	23,000	17,000	10,000

1. Using annuity equivalent method, determine the best replacement period for James (consider only 4 or 5 years). (9 marks)
2. Using perpetuity method, determine the best replacement period for James (consider only 4 or 5 years). Do you arrive with the same conclusion as part (a) above? Explain why? (6 marks)

If the salvage value of the machinery in year 5 turns out to be $15,000 rather than $10,000 as you initially expected, would you recommend James to replace the machinery in 4 or 5 years?