Question

BAK Corp. is considering purchasing one of two new diagnostic machines. Either machine would make it possible for the company to bid on jobs that it currently isn’t equipped to do. Estimates regarding each machine are provided below. Machine A Machine B Original cost $76,700 $188,000 Estimated life 8 years 8 years Salvage value 0 0 Estimated annual cash inflows $20,100 $40,200 Estimated annual cash outflows $4,910 $10,130 Click here to view the factor table. Calculate the net present value and profitability index of each machine. Assume a 9% discount rate. (If the net present value is negative, use either a negative sign preceding the number eg -45 or parentheses eg (45). Round answer for present value to 0 decimal places, e.g. 125 and profitability index to 2 decimal places, e.g. 10.50. For calculation purposes, use 5 decimal places as displayed in the factor table provided.) Machine A Machine B Net present value enter a dollar amount rounded to 0 decimal places enter a dollar amount rounded to 0 decimal places Profitability index enter the profitability index rounded to 2 decimal places enter the profitability index rounded to 2 decimal places Which machine should be purchased? select a machine should be purchased.

Answer 1

	Machine A	Machine B
Original cost	$76,700	$188,000
Estimated life (in years)	8	8
Salvage value	0	0
Estimated annual cash inflows	$20,100	$40,200
Estimated annual cash outflows	$4,910	$10,130
Estimated net annual cash inflows (Cash inflows - cash outflows)	$15,190	$30,070
Present value interest factor of an annuity of $ @ 9% for 8 years	5.535	5.535
Present value of future net cash inflows	$84,077	$166,437
Net Present value	$7,377	-$21,563
Profitability Index	1.10	0.89

Working notes:

Net Present Value = Present value of all future cash flows from the machine – Initial Investment

Profitability Index = Present value of all future cash flows from the machine / Initial Investment

In the above table, original cost, estimated life etc. for both the machines are given. The future net annual cash inflows from each machine are calculated as future annual cash inflows less cash outflows. Present value interest factor for an annuity @ 9 % for 8 years is taken from PVIFA tables (since discount rate is 9% and cash inflows will be received each year for 8 years).

Present value of future net cash inflows is calculated as Estimated net annual cash inflows in the future * Present value factor. For e.g. for machine A, present value of future net cash inflows = $15,190 * 5.535=$84,077.

Net Present value = Present value of all future cash flows from the machine – Initial Investment. For e.g. for machine A, NPV = $84,077 - $76,700 = $7,377, while NPV is negative for machine B ($166,437 - $188,000 = -$21,563).

Profitability Index for machine A = $84,077 / $76,600 = 1.10

Profitability Index for machine B = $166,437 / $188,000 = 0.89

So, considering both NPV and Profitability Index, machine A should be purchased since it has better NPV and better Profitability Index.