A company has two alternatives for selecting a new machine to replace its existing machine. The cash flows under the two alternatives are as follows: Machine-A (in lakh) Machine-B (in lakh) Year 0 cash outflow 25 40 Year

CS Professional · Financial, Treasury and Forex Management · PYQS · December 2015
A company has two alternatives for selecting a new machine to replace its existing machine. The cash flows under the two alternatives are as follows: Machine-A (in lakh) Machine-B (in lakh) Year 0 cash outflow 25 40 Year 1 cash inflow Nil 10 Year 2 cash inflow 5 14 Year 3 cash inflow 20 16 Year 4 cash inflow 14 17 Year 5 cash inflow 14 15 You are required to appraise the two alternatives using net present value and profitability index methods. The cost of capital of the company is 15%.

Answer & Explanation:

(i) Computation of NPV Year Cash flows (₹ in lakh) Machine A Cash flows (₹ in lakh) Machine B PV Factor @ 15% PV (₹ in lakh) Machine A PV (₹ in lakh) Machine B 0 (25) (40) 1.0000 (25) (40) 1 - 10 0.8696 - 8.70 2 5 14 0.7561 3.78 10.59 3 20 16 0.6575 13.15 10.52 4 14 17 0.5718 8.01 9.72 5 14 15 0.4972 6.96 7.46 NPV 6.90 6.99 (ii) Profitability index (PI) PI = PV of cash inflows/ PV of cash outflows PI of Machine A = ₹31.90 lakh/ ₹25 lakh = 1.28 PI of Machine B = ₹46.99 lakh/ ₹40 lakh = 1.17 Conclusion: Considering the Net Present Value Method, though both the machines have positive NPVs, but Machine B has a higher NPV and may be recommended. Supplementing the analysis with profitability index method, Machine A has a higher PI than machine B. As both the machines have positive NPV, the final decision has to be given in confirmation with NPV & PI method. Therefore, machine B is recommended to replace the existing machine.

Topics: Capital Budgeting

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