Question

Norma and Fred Buyalot are buying a new combine. They have narrowed their options to two combines and must purchase one. Each combine will provide the same cash inflows, but differ in initial cost, operating costs and salvage value. Machine A's purchase price is $120,000, will cost $2,500 per year to run, and has a salvage value of $10,000. Machine B is priced at $100,000, will cost $3,000 per year to run, and has a salvage value of $5,000. Both machines have a useful life of ten years. Based on the net present value method and a 9% cost of capital, which machine should they buy? NPVa = NPVb =

Answer 1

Calculating which machine to buy based on NPV:

Year	Cash Flows of machine A ($)	Cash Flows of machine B ($)	PV Factor @ 9%	Present Value of Machine A ($)	Present Value of Machine B ($)
0	(120,000.00)	(100,000.00)	1.0000	(120,000.00)	(100,000.00)
1	(2,500.00)	(3,000.00)	0.9174	(2,293.58)	(2,752.29)
2	(2,500.00)	(3,000.00)	0.8417	(2,104.20)	(2,525.04)
3	(2,500.00)	(3,000.00)	0.7722	(1,930.46)	(2,316.55)
4	(2,500.00)	(3,000.00)	0.7084	(1,771.06)	(2,125.28)
5	(2,500.00)	(3,000.00)	0.6499	(1,624.83)	(1,949.79)
6	(2,500.00)	(3,000.00)	0.5963	(1,490.67)	(1,788.80)
7	(2,500.00)	(3,000.00)	0.5470	(1,367.59)	(1,641.10)
8	(2,500.00)	(3,000.00)	0.5019	(1,254.67)	(1,505.60)
9	(2,500.00)	(3,000.00)	0.4604	(1,151.07)	(1,381.28)
10	7,500.00	2,000.00	0.4224	3,168.08	844.82
			NPV	(131,820.04)	(117,140.92)

Note- Year 10 Cash flows :

Machine A = Salvage Value - Operating Cost = $10,000 - $2500 = $7500

Machine B = Salvage Value - Operating Cost = $5,000 - $3000 = $2000

NPV of machine A is - $ 131,820.04  

NPV of machine B is - $ 117,140.92

Since, NPV of Machine B is less, thus you should buy Machine B as it cost less based on Present Value.

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