Question

Davis Industries is considering two alternative machines. Machine A has an expected life of 4 years, will cost $10 million, and will produce net cash flows of $3 million per year. Machine B has a life of 10 years, will cost $13 million, and will produce net cash flows of $2.5 million per year. Inflation in operation costs, machine costs is expected to be zero, and the company’s cost of capital is 10. Which machine should Davis Industries select?

Answer 1

Evaluation of Investment proposal using NPV Decision Rule

As per NPV Decision Rule, the Project should be accepted only if the NPV is Positive, else, Reject the Project.

Net Present Value (NPV) of MACHINE-A

Year	Annual Cash flow ($ in Million)	Present Value factor at 10%	Present Value of Annual Cash flow ($ in Million)
1	3.00	0.90909	2.73
2	3.00	0.82645	2.48
3	3.00	0.75131	2.25
TOTAL			9.51

Net Present Value (NPV) = Present value of annual cash inflows – Initial investment costs

= $9.51 Million - $10 Million

= -$0.49 Million (Negative NPV)

Net Present Value (NPV) of MACHINE-B

Year	Annual Cash flow ($ in Million)	Present Value factor at 10%	Present Value of Annual Cash flow ($ in Million)
1	2.50	0.90909	2.27
2	2.50	0.82645	2.07
3	2.50	0.75131	1.88
4	2.50	0.68301	1.71
5	2.50	0.62092	1.55
6	2.50	0.56447	1.41
7	2.50	0.51316	1.28
8	2.50	0.46651	1.17
9	2.50	0.42410	1.06
10	2.50	0.38554	0.96
TOTAL			15.36

Net Present Value (NPV) = Present value of annual cash inflows – Initial investment costs

= $15.36 Million - $13 Million

= $2.36 Million

DECISION

Davis Should select MACHINE-B, since it has the Net Present Value of Positive $2.36 Million.

NOTE

The formula for calculating the Present Value Inflow Factor (PVIF) is [1 / (1 + r)ⁿ], where “r” is the Discount Rate/Cost of capital and “n” is the number of years.