The Perez Company has the opportunity to invest in one of two mutually exclusive

Question

The Perez Company has the opportunity to invest in one of two mutually exclusive machines that will produce a product it will need for the foreseeable future. Machine A costs $8 million but realizes after-tax inflows of $4.5 million per year for 4 years. After 4 years, the machine must be replaced. Machine B costs $17 million and realizes after-tax inflows of $4.5 million per year for 8 years, after which it must be replaced. Assume that machine prices are not expected to rise because inflation will be offset by cheaper components used in the machines. The cost of capital is 13%.

By how much would the value of the company increase if it accepted the better machine? Enter your answer in millions. For example, an answer of $1.2 million should be entered as 1.2, not 1,200,000. Round your answer to two decimal places.
$   million

What is the equivalent annual annuity for each machine? Enter your answer in millions. For example, an answer of $1.2 million should be entered as 1.2, not 1,200,000. Round your answers to two decimal places.

Machine A $   million Machine B $   million

Explanation / Answer

DEFINITION of 'Equivalent Annual Annuity Approach - EAA' One of two methods used in capital budgeting to compare mutually exclusive projects with unequal lives. The equivalent annual annuity (EAA) approach calculates the constant annual cash flow generated by a project over its lifespan if it was an annuity.

Statement showing the Evalution of Two Machines

higher than that of Machine B.

DEFINITION of 'Equivalent Annual Annuity Approach - EAA' One of two methods used in capital budgeting to compare mutually exclusive projects with unequal lives. The equivalent annual annuity (EAA) approach calculates the constant annual cash flow generated by a project over its lifespan if it was an annuity.

Statement showing the Evalution of Two Machines

Amount in Mn $ Reference Particulars Machine A Machine B 1 Purchase Cost                         8.00                             17.00 2 Life of Machines (Years)                               4                                      8 3 Inflow after Tax                         4.50                                4.50 4 Cumulative Present Value Factor for 1-4 years @ 13% (Refer Working Note 1)                         2.97 5 Cumulative Present Value Factor for 1-8 years @ 13% (Refer Working Note 1)                                4.80 6 Cost Inflow of Machines (3x4) & (3x5)                       13.39                             21.59 7 Net Cash Inflow (1-6)                         5.39                                4.59 8 Equivalent Annual Cash Inflow (7/4) & (7/5)                         1.81                                0.96 Decision : The Perez company should invest in Machine A as Equivalent Cash Inflow of Machine A is

higher than that of Machine B.

Note 1: Years CPVF @ 13% CPVF @ 13% 4 Years 8 Years 1             0.8850             0.8850 2             0.7831             0.7831 3             0.6931             0.6931 4             0.6133             0.6133 5             0.5428 6             0.4803 7             0.4251 8             0.3762             2.9745             4.7988

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