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CMA Intermediate · Financial Management and Business Data Analytics · Capital Budgeting

Sundaram Textiles must choose one of two machines at a 10% cost of capital, each of which can be replaced with an identical one at the end of its life. Machine A has a 3-year life and an NPV of Rs 29,843. Machine B has a 5-year life and an NPV of Rs 37,908. The PV annuity factors at 10% are 2.4869 for 3 years and 3.7908 for 5 years. Which choice is supported by the equivalent annual annuity (EAA) approach?

Machine A should be chosen. Its equivalent annual annuity is about Rs 12,000 (29,843 divided by 2.4869), against Rs 10,000 for Machine B (37,908 divided by 3.7908). Raw NPV favours B only because B runs for more years, so EAA is the proper comparison for unequal lives.

  1. AMachine B, because its NPV of Rs 37,908 is higher than Machine A's
  2. BMachine A, because its EAA of about Rs 12,000 exceeds Machine B's EAA of about Rs 10,000Correct
  3. CMachine B, because its EAA of about Rs 12,000 exceeds Machine A's EAA of about Rs 10,000
  4. DBoth are equally good because both have positive NPVs

Explanation

EAA = NPV / annuity factor. For A it is 29,843 / 2.4869 = about Rs 12,000 a year. For B it is 37,908 / 3.7908 = Rs 10,000 a year. Comparing raw NPVs favours B only because B's life is longer, so that comparison is not like-for-like.

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