The Fernandez Company has the opportunity to invest in one of two mutually exclu

Question

The Fernandez Company has the opportunity to invest in one of two mutually exclusive machines that will produce a product that the company will need for the next 8 years. Machine A costs $10 million but will provide after-tax inflows of $4 million per year for 4 years. If Machine A is replaced, its cost will be $12 million due to inflation and its cash inflows will increase to $4.2 million due to production efficiencies. Machine B costs $15 million and will provide after-tax inflows of $3.5 million per year for 8 years. If the WACC is 10%, which machine should Fernandez acquire?

Explanation / Answer

We compute NPV of each option

If machine A is acquired, NPV ($ million) = - 10 + 4 x PVIFA(10%, 4) = - 10 + 4 x 3.1699 = - 10 + 12.68 = 2.68

If machine A is replaced, NPV ($ million) = - 12 + 4.2 x PVIFA(10%, 4) = - 12 + 4.2 x 3.1699 = - 12 + 13.31 = 1.31

If machine B is acquired, NPV ($ million) = - 15 + 3.5 x PVIFA(10%, 8) = - 15 + 3.5 x 5.3349 = - 15 + 18.67 = 3.67

Since NPV is highest if machine B is acquired, he should acquire B.

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