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A company is considering the replacement of its existing machine which is obsolete and unable to meet the rapidly rising demand for its product.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 buy 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 (in $1000)	-26	0	6	20	15	14
Machine B (in $1000)	-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.

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?

HINT: Use the NPV calculator linked on the left-hand side of the page.
If you use excel’s NPV function, do not forget you should include only the cash inflows (in the values line) and when you get an answer, you must deduct the cost of the machine to get the final NPV.

Answer 1

Following screenshot shows the NPV of both machines which implies machine B with a higher NPV is better to invest in:

IRR is the rate at which NPV becomes 0. Using Excel goal seek function, we can calculate the IRR for bothe the machines as shown in the following screenshots:

IRR for Machine 1 is 23.3333% and that for Machine 2 is 22.6279829% as IRR is a return, higher return is better so according to IRR rule, Machine 1 is better.

Payback period calculation are as follows:

Opening balance= previous year's closing balance

Closing balance = Opening balance+Investment-CF

As machines in both investments can be recovered by the end of year 3, payback period for both machines is 3 therefore according to payback period either machine is good for investment.

Out of all the above approaches, NPV is the best approach and whenever there is a contradiction, NPV approach reign supreme and therefore the final decision should be made according to this approach which suggests machine 2 is a better investment as it has a higher NPV. One big reason is that a large part of the investment is recovered in 1st year in case of machine 2 and due to discounting effect this is a game changer.