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CA Intermediate · Financial Management and Strategic Management · Investment Decisions

Zenith Packaging must choose between two mutually exclusive machines, to be replaced with identical machines in future. Cost of capital is 10%. Machine A has a 5-year life and NPV of ₹1,89,550. Machine B has a 2-year life and NPV of ₹1,04,160. Annuity factors at 10% are 3.791 for 5 years and 1.736 for 2 years. Which choice is correct under the equivalent annual annuity approach?

Machine B should be chosen. Dividing each NPV by its annuity factor gives an equivalent annual annuity of ₹50,000 for A and ₹60,000 for B. With unequal lives and replacement, annual equivalents are the right comparison, not raw NPV, which favours A misleadingly.

  1. AMachine A, because its NPV of ₹1,89,550 is higher
  2. BMachine B, because its equivalent annual annuity of ₹60,000 exceeds A's ₹50,000Correct
  3. CMachine A, because its equivalent annual annuity is ₹60,000
  4. DIndifferent, because both have positive NPV

Explanation

EAA of A = 1,89,550 / 3.791 = ₹50,000. EAA of B = 1,04,160 / 1.736 = ₹60,000. Since the lives are unequal and the machines will be replaced, annual equivalents must be compared, so B is preferred. Choosing A on raw NPV ignores the unequal lives.

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