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 percent, and the inflation rate is 5 percent.

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.

b.Suppose the inflation rate increases to 25 percent. The real interest rate stays at 6 percent. Recalculate the level nominal annuities. Note that the ranking of machines A and B appears to change. Why?