- Two machines are not identical in many respects. Following are the information regarding the two. The estimated life of both machines is five years, leaving no salvage value at the end.
Cost (Rs.) Anticipated Cash flow after tax per year (Rs.)
| Yr. 1 | Yr. 2 | Yr. 3 | Yr. 4 | Yr. 5 | |
| Machine M 6,25,000 | – | 1,25,000 | 5,00,000 | 3,50,000 | 1,50,000 |
| Machine N 10,00,000 | 2,50,000 | 3,50,000 | 4,00,000 | 4,25,000 | 2,00,000 |
The company’s cost of capital is 16%. You are required to make an appraisal of the two machines and advise the company using (i) NPV (ii) Internal rate of return (IRR).
| (Given : present value of Re. 1) | End of Year | 16% | 18% | 20% | |
| 1 | 0.862 | 0.847 | 0.833 | ||
| 2 | 0.743 | 0.718 | 0.694 | ||
| 3 | 0.641 | 0.609 | 0.579 | ||
| 4 | 0.552 | 0.516 | 0.482 | ||
| 5 | 0.476 | 0.437 | 0.402 | 16 |
To evaluate the two machines, we will calculate the Net Present Value (NPV) and Internal Rate of Return (IRR) for each machine using the given cost of capital of 16%.
For Machine M: Year 1: NPV = Cash flow / (1 + Cost of Capital) = Rs. 6,25,000 / (1 + 0.16) = Rs. 5,39,224.14 Year 2: NPV = 0 (No cash flow) Year 3: NPV = Rs. 1,25,000 / (1 + 0.16)^3 = Rs. 83,822.40 Year 4: NPV = Rs. 5,00,000 / (1 + 0.16)^4 = Rs. 2,85,853.65 Year 5: NPV = Rs. 3,50,000 / (1 + 0.16)^5 = Rs. 1,54,112.63
Total NPV for Machine M = Rs. 5,39,224.14 + Rs. 83,822.40 + Rs. 2,85,853.65 + Rs. 1,54,112.63 = Rs. 10,62,012.82
For Machine N: Year 1: NPV = Rs. 10,00,000 / (1 + 0.16) = Rs. 8,62,068.97 Year 2: NPV = Rs. 2,50,000 / (1 + 0.16)^2 = Rs. 1,74,241.38 Year 3: NPV = Rs. 3,50,000 / (1 + 0.16)^3 = Rs. 1,81,185.07 Year 4: NPV = Rs. 4,00,000 / (1 + 0.16)^4 = Rs. 1,69,598.56 Year 5: NPV = Rs. 4,25,000 / (1 + 0.16)^5 = Rs. 1,77,700.86
Total NPV for Machine N = Rs. 8,62,068.97 + Rs. 1,74,241.38 + Rs. 1,81,185.07 + Rs. 1,69,598.56 + Rs. 1,77,700.86 = Rs. 15,64,794.84
(i) NPV Comparison: The NPV of Machine M is Rs. 10,62,012.82 and the NPV of Machine N is Rs. 15,64,794.84. Therefore, based on the NPV criterion, Machine N is preferred over Machine M as it has a higher NPV.
(ii) IRR Calculation: To calculate the IRR, we equate the present value of cash flows to the initial cost of the machine and solve for the discount rate that makes it zero.
For Machine M: IRR = 16% (Given cost of capital) since NPV is positive for all discount rates.
For Machine N: IRR = Between 16% and 18% since the NPV is positive at 16% but negative at 18% according to the given discount rate table.
In conclusion, based on the NPV criterion, Machine N is preferred over Machine M. However, the IRR analysis suggests that both machines have an IRR greater than the cost of capital (16%), indicating that both machines are expected to generate a return higher than the required rate of return.
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