10-17 The Perez Company has the opportunity to invest in one of two mutually exc

Question

10-17 The Perez Company has the opportunity to invest in one of two mutually exclusive machines that will produce a product it will need for the foreseeable future. Machine A costs $10 million but realizes after-tax inflows of $4 million per year for 4 years. After 4 years, the machine must be replaced. Machine B costs $15 million and realizes after-tax inflows of $3.5 million per year for 8 years, after which it must be replaced. Assume that machine prices are not expected to rise because inflation will be offset by cheaper components used in the machines. The cost of capital is 10%.

A. By how much would the value of the company increase if it accepted the better machine?

B. What is the equivalent annual annuity for each machine?

Explanation / Answer

a) Based on excel sheet below Machine B is better beacuse NPV of A is better than NPV of B . NPV of A is 4.51 and NPV of B is and NPV of B is 3.67.million

b) Equivalent annual annuity of each machine = r(NPV)/(1 -(1+r)-n)
EAA of Machine A = 10%* ( 4.51)/(1 -(1 + 10%)-8)= 0.8453 million
EAA of Machine B = 10%* ( 3.67)/(1 -(1 + 10%)-8)= 0.6879 million

Best Of Luck. God Bless

Machine A A B C D E F G H 1 Year 0 1 2 3 4 5 6 7 8 2 Cost of Machine -10 3 After Tax Cash flows 4 4 4 4 4 Cost of Machine -10 5 After Tax Cash flows 4 4 4 4 6 Free Cash Flows -10 4 4 4 -6 4 4 4 4 7 Discount Rate 10% 8 NPV 4.51 NPV(A7,B6:G6)+A6 Machine B A B C D E F G H 1 Year 0 1 2 3 4 5 6 7 8 2 Cost of Machine -15 3 After Tax Cash flows 3.5 3.5 3.5 3.5 3.5 3.5 3.5 3.5 4 Free Cash Flows -15 3.5 3.5 3.5 3.5 3.5 3.5 3.5 3.5 5 Discount Rate 10% 6 NPV 3.67 NPV(A5,B4:G4)+A4

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