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CA Intermediate · Financial Management and Strategic Management · Investment Decisions

Meera Industries must choose one of two mutually exclusive machines, each of which can be replaced indefinitely with an identical one. Machine A has a 3-year life and an NPV of ₹90,075. Machine B has a 5-year life and an NPV of ₹1,15,360. The cost of capital is 12%; annuity factors at 12% are 2.402 for 3 years and 5 years 3.605. Which machine should be chosen and what is its equivalent annual annuity?

Machine A should be chosen, with an equivalent annual annuity of ₹37,500. Dividing each NPV by its annuity factor gives ₹37,500 for A and ₹32,000 for B. With unequal lives and repeated replacement, EAA is the right basis, so the higher raw NPV of B is misleading.

  1. AMachine B, because its NPV of ₹1,15,360 is higher
  2. BMachine A, with an equivalent annual annuity of ₹37,500Correct
  3. CMachine A, with an equivalent annual annuity of ₹90,075
  4. DMachine B, with an equivalent annual annuity of ₹32,000

Explanation

EAA of A = 90,075 / 2.402 = 37,500. EAA of B = 1,15,360 / 3.605 = 32,000. Since lives are unequal and replacement is repeated, the machine with the higher EAA, A, is preferred. Choosing B on raw NPV ignores the difference in project lives.

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