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CA Final · Advanced Financial Management · Advanced Capital Budgeting Decisions

Kaveri Industries must choose one of two mutually exclusive machines with a 10% cost of capital. Machine X: cost ₹2,00,000, operating cost ₹50,000 a year, life 3 years, PV of total costs ₹3,24,345 (EAC ₹1,30,421). Machine Y: cost ₹3,00,000, operating cost ₹40,000 a year, life 5 years (5-year annuity factor 3.7908). Both can be replaced with identical machines in future and neither has salvage value. Which conclusion is correct?

Machine Y should be chosen. Its EAC is about ₹1,19,139 against ₹1,30,421 for X. With unequal lives, raw present values of cost are not comparable, so costs must be annualised before choosing the lower one.

  1. AChoose X, because its PV of costs is lower than that of Y
  2. BChoose Y, because its EAC of about ₹1,19,139 is lower than X's ₹1,30,421Correct
  3. CChoose X, because its life is shorter and so riskier to avoid
  4. DChoose Y, because its EAC of about ₹1,51,632 is lower than X's

Explanation

PV of Y's costs = 3,00,000 + 40,000 × 3.7908 = 4,51,632. EAC = 4,51,632 ÷ 3.7908 ≈ ₹1,19,139, lower than X's ₹1,30,421. Comparing raw PVs (3,24,345 vs 4,51,632) is wrong because the lives are unequal.

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