Company UVW has to make a choice between two identical machines, in terms of Capacity, ‘A’ and ‘B’. They have been designed differently, but do exactly the same job. Machine ‘A’ costs Rs. 7,50,000 and will last for three years. It costs Rs. 2,00,000 per year to run. Machine ‘B’ is an economy model costing only Rs. 5,00,000, but will last for only two years. It costs Rs. 3,00,000 per year to run. The cash flows of Machine ‘A’ and ‘B’ are real cash flows. The costs are forecasted in rupees of constant purchasing power. Ignore taxes. The opportunity cost of capital is 9%.
Required:
Which machine the company UVW should buy?
The present value (PV) factors at 9% are:
Year t1 t2 t3
PVIF0.09.t 0.9174 0.8417 0.7722
Statement Showing the Evaluation of Two Machines
Machines A B
(i) Purchase Cost Rs. 7,50,000 Rs. 5,00,000
(ii) Life of Machine 3 years 2 years
(iii) Running Cost of Machine per year Rs. 2,00,000 Rs. 3,00,000
(iv) PVIFA 0.09, 3 2.5313
PVIFA 0.09, 2 1.7591
(v) PV of Running Cost of Machine Rs. 5,06,260 Rs. 5,27,730
(vi) Cash outflows of Machine {(i) + (v)} Rs. 12,56,260 Rs. 10,27,730
(vii) Equivalent PV of Annual Cash outflow (vi/iv) Rs. 4,96,290 Rs. 5,84,236
Recommendation: Company UVW should buy Machine ‘A’ since equivalent annual cash outflow is less than that of Machine B.
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