Question

Machines A and B are mutually exclusive and are expected to produce the following real cash flows:

Cash Flows ($ thousands)
Machine	C0	C1	C2	C3	C4
A	-117	115	135	150
B	-125	110	150	-50	200

The real opportunity cost of capital is 10%.

1. Calculate the NPV of each machine.                                                                      
2. Calculate the equivalent annual cash flow from each machine.                             
3. Which machine should you buy? Justify your answer.                                           
4. When appraising mutually exclusive investments in plant and equipment, financial managers calculate the investments' equivalent annual costs and rank the investments on this basis. Critically discuss why this is necessary and why not just compare the investments' NPVs?                                                                                                

Answer 1

ANSWER (a):-

ANSWER (b):-

Answer (c):- From the point of view of NPV, Machine A should be bought. ( HIGHER IS BETTER)

( Explanation :- Net present value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows over a period of time. )

From the point of view of EAC, Machine B should be bought (LOWER IS BETTER)

( Explanation :- Equivalent annual cost (EAC) is the cost per year for owning or maintaining an asset over its lifetime.  EAC helps to compare the cost effectiveness of two or more assets with different lifespans. )

But if we compare NPV and EAC, then EAC should be considered, so MACHINE B should be bought.

Answer (d):- When appraising mutually exclusive investments in plant and equipment, financial managers calculate the investments' equivalent annual costs and rank the investments on this basis. This is true statement as just comparing NPV is not a goot criteria os selection as gauging the profitability of investment with NPV relies heavily on assumptions and estimates, so there can be substantial room for error. It requires a lot of estimates and unforeseen expenses during and at the end of project whereas EAC is a better critera of making capital budgeting decision than NPV. Because with NPV, we are evaluating and adding up all of the cash flows. In contrast to this, EAC uses estimated lifespan, estimated maintenance, etc. in its calculation. So, financial managers must take EAC into their consideration.