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CA Intermediate · Financial Management and Strategic Management · Investment Decisions

Rohan Engineering must choose one of two mutually exclusive machines that it will replace on completion of their lives. Machine X has a 3-year life and NPV of ₹2,48,700. Machine Y has a 2-year life and NPV of ₹1,56,240. The cost of capital is 10%. Cumulative PV annuity factors at 10% are 1.736 for 2 years and 2.487 for 3 years. Which machine should be chosen using the equivalent annual annuity approach, and what is its EAA?

Machine X should be chosen, with an equivalent annual annuity of ₹1,00,000. Dividing each NPV by the annuity factor for its own life gives ₹1,00,000 for X and ₹90,000 for Y. X gives the higher annual value on a like-for-like basis.

  1. AMachine X, EAA ₹1,00,000Correct
  2. BMachine Y, EAA ₹90,000
  3. CMachine X, EAA ₹82,900
  4. DMachine Y, EAA ₹78,120

Explanation

EAA of X = 2,48,700 / 2.487 = ₹1,00,000. EAA of Y = 1,56,240 / 1.736 = ₹90,000. X has the higher EAA and is chosen. Dividing NPV by years (₹82,900 and ₹78,120) ignores time value and is wrong.

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