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CA Intermediate · Financial Management and Strategic Management · Investment Decisions

Kaveri Industries must choose one of two mutually exclusive machines, each to be replaced by an identical machine at the end of its life. The cost of capital is 10%. Machine A has a 5-year life and NPV of ₹7,58,200. Machine B has a 3-year life and NPV of ₹5,22,270. Annuity factors at 10% are 3.791 for 5 years and 2.487 for 3 years. Which statement is correct?

Machine B should be chosen because its equivalent annual annuity is ₹2,10,000 against ₹2,00,000 for Machine A. With unequal lives and repeated replacement, NPV is converted into an annual figure by dividing by the annuity factor, so raw NPV comparison misleads.

  1. AChoose Machine A because its NPV of ₹7,58,200 is higher, and unequal lives do not matter
  2. BChoose Machine B because its equivalent annual annuity of ₹2,10,000 exceeds A's ₹2,00,000Correct
  3. CChoose Machine A because its equivalent annual annuity is ₹2,00,000, which is higher than B's
  4. DChoose Machine B because its NPV is lower and so it carries less risk

Explanation

EAA of A = 7,58,200 / 3.791 = ₹2,00,000. EAA of B = 5,22,270 / 2.487 = ₹2,10,000. With unequal lives and replacement, projects are compared on equivalent annual annuity, so B is better. Comparing raw NPVs favours A wrongly.

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