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 $77,000 $188,000 Estimated life 8 years 8 years Salvage value 0 0 Estimated annual cash inflows $19,900 $40,200 Estimated annual cash outflows $4,800 $9,860.

Calculate the net present value and profitability index of each machine. Assume a 9% discount rate

Which machine should be purchased?

Answer 1

Machine A:

Initial Investment = $77,000

Annual Net Cash Flows = Annual Cash Inflows - Annual Cash Outflows
Annual Net Cash Flows = $19,900 - $4,800
Annual Net Cash Flows = $15,100

Present Value of Net Cash Flows = $15,100 * PVA of $1 (9%, 8)
Present Value of Net Cash Flows = $15,100 * 5.53482
Present Value of Net Cash Flows = $83,575.78

Net Present Value = Present Value of Net Cash Flows - Initial Investment
Net Present Value = $83,575.78 - $77,000
Net Present Value = $6,575.78

Profitability Index = Present Value of Net Cash Flows / Initial Investment
Profitability Index = $83,575.78 / $77,000
Profitability Index = 1.09

Machine B:

Initial Investment = $188,000

Annual Net Cash Flows = Annual Cash Inflows - Annual Cash Outflows
Annual Net Cash Flows = $40,200 - $9,860
Annual Net Cash Flows = $30,340

Present Value of Net Cash Flows = $30,340 * PVA of $1 (9%, 8)
Present Value of Net Cash Flows = $30,340 * 5.53482
Present Value of Net Cash Flows = $167,926.44

Net Present Value = Present Value of Net Cash Flows - Initial Investment
Net Present Value = $167,926.44 - $188,000
Net Present Value = -$20,073.56

Profitability Index = Present Value of Net Cash Flows / Initial Investment
Profitability Index = $167,926.44 / $188,000
Profitability Index = 0.89

BAK Corp. should purchase Machine A as its NPV and PI are higher than those of Machine B.