Question

A company is considering the replacement of its existing machine which is obsolete and unable to meet the rapidly rising demand for its product. The company is faced with two alternatives: (i) to buy Machine A which is similar to the existing machine or (ii) to go in for Machine B which is more expensive and has greater capacity. The cash flows at the present level of operations under the two alternatives are as follows:

	0	1	2	3	4	5
Machine A	-26		6	20	15	14
Machine B	-40	9	15	16	17	18

The company’s cost of capital is 7%. The finance manager asks you to evaluate the machines by calculating the following: 1.Net Present Value; 2. Payback period; and 3. the IRR.

You show your calculation results to the finance manager, who is still unable to make up his mind as to which machine to recommend. What advice would you give about the proposed investment?

Answer 1

NPV = PV of cash Inflows - PV of Cash Outflows

Payback period is the period in which initilinvestment is recovered.

in both cases amount is recovered in 3 years.

IRR is the rate at which PV of cash inflows are equal to PV of Cash Outflows.

Machine A:

IRR = rate at which least +ve NPV + [ NPV at that rate / Change in NPV due to inc of 1% in int rate ] * 1%

= 23% + [ 0.24 / 0.73 ] *1%

= 23% + 0.33%

= 23.33%

Machine B:

IRR = rate at which least +ve NPV + [ NPV at that rate / Change in NPV due to inc of 1% in int rate ] * 1%

= 22% + [ 0.60 / 0.95 ] *1%

= 22% + 0.63%

= 22.63%

Acc to NPV -- Machine B is suggested

Payback period - Both are equally good

IRR - Machine A is suggested.