solution to NPV Problem

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srinivas (Querist)
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08 November 2008 1. A company is considering the replacement of its existing machine which is obsolete and unable to meet the rising demand for its product. The company is faced with two alternatives: to buy Machine A which is similar to the existing machine or to go in for Machine B which is more expensive and has much greater capacity. The cash flows at the present level of operations under the two alternatives are as follows:-

Machine Immediate Cash outflows Cash inflows (in lakhs of Rs.) at the end of
(in lakhs of Rs.) 1st IInd IIIrd Ivth Vth
year year year year year
Machine A 25 - 5 20 14 14
Machine B 40 10 14 16 17 15

The company’s cost of capital is 10%

The finance manager tries to appraise the machines by calculating the following :
1. Net Present Value
2. Profitability Index
3. Payback period; and
4. Discounted payback period

At the end of his calculations, however, the finance manager is unable to make up his mind as to which machine to recommend.

You are required to make these calculations and in the light thereof to advise the finance manager about the proposed investment.

Note: Present values of Re.1 at 10% discount rate are as follows:

Year 0 1 2 3 4 5
P.V. 1.00 .91 .83 .75 .68 .62