Question

Comparing Mutually Exclusive ProjectsVandelay Industries is considering the purchase of a new machine for the production of latex. Machine A costs $1.98 million and will last for six years. Variable costs are 35 percent of sales and fixed costs are $187,000 per year. Machine B costs $5,400,000 and will last for nine years. Variable costs for this machine are 30 percent and fixed costs are $145,000 per year. The sales for each machine will be $12.4 million per year. The required return is 10 percent and the tax rate is 21 percent. Both machines will be depreciated on a straight-line basis. If the company plans to replace the machine when it wears out on a perpetual basis, which machine should you choose?

Answer 1

	Particulars	Machine A	Machine B
A	Sales	12,400,000	12,400,000
B	Variable cost	3,720,000	3,720,000
C	Fixed Cost	187,000	187,000
D	Depreciation	330,000	600,000
E	Operating profit (A - B-C-D)	8,163,000	7,893,000
F	Tax(E* 21%)	1,714,230	1,657,530
G	Depreciation	330,000	600,000
H	Cash flows (E -F + G)	6,778,770	6,835,470
I	Life	6 years	9 years
J	Present Value Annuity factor @ 10%	4.3553	5.7590
K	Present Value of cash inflows (H * J)	29,523,311	39,365,635
L	Cash Outflows	1,980,000	5,400,000
M	NPV ( K - L )	27,543,311	33,965,635
N	Equivalent Annual Cost( M / J)	6,324,147	5,897,811

Here Depreciation for Machine A = 1980000/ 6 = 330000

Depreciation for Machine B = 5400000 / 9 = 600000

Present value of annuity factor is calculate by taking discounting factor for the number of periods and then adding them up.

Net Present value = Present value of inflows - Present value of cash outflows

We need to calculate the Equivalent annual cash flow coming from each of the machines to take the decisions.

EAC can be calculated as below,

NPV = Equivalent Annual cash flows ( PVAF, R, N)

EAC for Machine A, 27543311 = EAC ( PVAF, 10%, 6)

EAC for Machine A = 6324147

EAC for Machine B, 33965635 = EAC ( PVAF , 10% , 9)

EAC for Machine B = 5897811

We should choose Machine A since Machine A has a higher EAC.