Question

Q1. There is a choice of investing in two mutually exclusive machines whose life is 8 years. A costs $11 million and will produce inflows of $5 million per year for 4 years. If A was replaced, its cost would be $12.5 million due to inflation and its cash inflows would increase to $5.5 million due to production efficiencies. Machine B costs $15 million and will provide after-tax inflows of $4.5 million per year for 8 years. If the WACC is 10%, which machine should be acquired? Solve using a financial calculator. Do it manually. Do not use Excel!

Answer 1

We need to calculate net present value (NPV) of both machines.

NPV is the difference between sum of present value of cash inflows and initial investment.

Machine A will be replaced in year 5 at the cost of $12.5 million. so, year 5 cash inflow would be $5.5 million - $12.5 million = -$7 million. $12.5 million cost of machine is cash outflow.

NPV of Machine A

Press CF and 2ND key in the calculator and then press CE/C key to clear CF register. now you'll see CF₀=0. input -11 and press enter and then down arrow key.

in C01 input 5 and press enter and down arrow key. next you'll see F01= 1.00. enter 4 and press down arrow key. we entered 4 in F01 because 5 million cash inflow per year for 4 years. F is for frequency. now you'll see C02. enter -7 press enter and down arrow key. next you'll see F02= 1.00. leave it as it is and press down arrow key.

now you'll see C03. enter 5.5 press enter and down arrow key. next you'll see F03= 1.00. enter 3 and press down arrow key for 5.5 cash inflow for next 3 years. when you get C04= 0.00 then press NPV key. you'll get I = 0.00. input 10 and press enter followed by down arrow key. you'll get NPV= 0.00. press CPT key and you'll get NPV = 8.996 million.

So, NPV of Machine A is $8.996 million.

NPV of Machine B

Press CF and 2ND key in the calculator and then press CE/C key to clear CF register. now you'll see CF₀=0. input -15 and press enter and then down arrow key.

in C01 input 4.5 and press enter and down arrow key. next you'll see F01= 1.00. enter 8 and press down arrow key. we entered 8 in F01 because 4.5 million cash inflow per year for 8 years. F is for frequency. next you'll see C02= 0.00. press NPV key. you'll get I = 0.00. input 10 and press enter followed by down arrow key. you'll get NPV= 0.00. press CPT key and you'll get NPV = 9.007 million.

So, NPV of Machine B is $9.007 million.

Machine B should be acquired because it has higher positive NPV of $9.007 million than Machine A's positive NPV of $8.996 million.