Your company is considering three machines to stamp metal in its factory. Machin

Question

Your company is considering three machines to stamp metal in its factory. Machine A costs $500,000, it has a life of four years, and it will generate after-tax cash flows of $190,000 each year. Machine B costs $300,000, it has a life of three years, and it will generate after-tax cash flows of $150,000 each year. Machine C costs $760,000, it has a life of six years, and it will generate after-tax cash flows of $210,000 each year. If your company’s weighted average cost of capital is 13% per year, which machine should it chose? What is the annual benefit of the best machine?

Explanation / Answer

Solution: Weighted Average Cost of Capital (WACC) = 13% NPV= Present Value of Cash Inflows- Present Value of Initial Cost Calculation of EANPV: Machine A Particulars Time PVF @13% Amount (in $)    Present Value (in $) Initial Cost 0 1 500,000 5,00,000 PV of Cash Outflows (PVCO) (A) 5,00,000 Cash inflows: Annual Cash Inflows 1-4 years 2.9745 190,000 5,65,155 PV of Cash Inflows =PVCI (B) 5,65,155 NPV= PVCI - PVCO (B)- (A) 65,155 Equivalent Annual NPV (EANPV)= NPV/ PVAF 65,155/2.9745= 21,904.52 Calculation of EANPV: Machine B Particulars Time PVF @13% Amount (in $)    Present Value (in $) Initial Cost 0 1 300,000 3,00,000 PV of Cash Outflows (PVCO) (A) 3,00,000 Cash inflows: Annual Cash Inflows 1-3 years 2.3612 150,000 3,54,180 PV of Cash Inflows =PVCI (B) 3,54,180 NPV= PVCI - PVCO (B)- (A) 54,180 Equivalent Annual NPV (EANPV)= NPV/ PVAF 54,180/2.3612= 22,945.96 Calculation of EANPV: Machine C Particulars Time PVF @13% Amount (in $)    Present Value (in $) Initial Cost 0 1 760,000 7,60,000 PV of Cash Outflows (PVCO) (A) 7,60,000 Cash inflows: Annual Cash Inflows 1-6 years 3.9975 210,000 8,39475 PV of Cash Inflows =PVCI (B) 8,39,475 NPV= PVCI - PVCO (B)- (A) 79,475 Equivalent Annual NPV (EANPV)= NPV/ PVAF 79,475/3.9975= 19,881.18 Conclusion: Machine B should be choose as there is higher equivalent annual NPV. Annual Benefit I.e. equivalent annual NPV is $22,945.96

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