Question

The Indian subsidiary of BDC, a US multinational, has the opportunity to invest in one of two mutually exclusive machines. Both machines can produce the same product for the Indian market. Machine A has a life of 9 years, costs 120 million Indian Rupees (IRP) and will produce after-tax inflows of 2.5 million IRP per year at the end of each year. Machine B has a life of 7 years, costs 150 million and will produce after-tax inflows of 3.5 million IRP per year at the end of each year. Assuming the machines can be replaced indefinitely at constant prices, which machine should BCD choose? Assume a cost of capital of 12%. The current spot rate is 0.013 US$/IRP.

Answer 1

Solution:

We shall evaluate the project on the basis of Net Present Value:

Machine A:

Annual After tax inflows=2.5 Million IRP

Present Value of Annual After tax inflows=Annual After tax inflows*Pressent value annuity factor@12% for 9 years

=2.5 million*5.32825

=13.320625 million IRP

Net present value of Machine A=Present Value of Annual After tax inflows-Cost of Machine

=13.320625 million-120 million

=-106.679375 million IRP

Machin B:

Annual After tax inflows=3.5 million IRP

Present Value of Annual After tax inflows=Annual After tax inflows*Present value annuity factor @12% for 7 years

=3.5 million IRP*4.563756

=15.973146 million IRP

Net Present value of Machine B=Present Value of Annual After tax inflows-Cost of Machine

=15.973146 million IRP-150 million IRP

=-1340.026854 million IRP

In case of mutually exclusive projects,project with highest net present value should be selected.In the given case both the machines have negative net present value.Accordingly if the company has to select one of them,then the Machine B should be selected as it has lower negative NPV otherwise both the machines are not profitable to the company.