Question

MKM International is seeking to purchase a new CNC machine in order to reduce costs. Two alternative machines are in consideration Machine 1 costs $500,000 but yields a 10 percent savings (net benefit) over the current machine used. Machine 2 costs $900,000 but yields a 20 percent savings (net benefit) over the current machine used. In order to meet demand, the following forecasted cost information for the current machine is also provided. Year 1 2 3 4 5 Projected Cost 1,000,000 1,350,000 1,400,000 1,450,000 2,550,000 a) Based on the NPV of the cash flows for these five years, which machine should MKM International Purchase? Assume a discount rate of 12 percent.

Answer 1

Machine A: Here, it is given that if Machine A is purchased for $500,000 there will be saving of 10% over the current machine used. So, here we have to compare that if we invest $500,000 how total cost will be saved in future. Year 1 2 Cost for Current Machine 1,000,000.00 1,350,000.00 1,400,000.00 1,450,000.00 2,550,000.00 Present Value Saving @10% Factor @ 12% 100,000.00 0.89 135,000.00 0.80 140,000.00 0.71 145,000.00 0.64 255,000.00 0.57 Present Value 89,285.71 107,621.17 99,649.23 92,150.12 144,693.85 3 4 5 Total Present Value of Saving 533,400.09 Less : Initial Investment (500,000.00) NPV 33,400.09 Machine B: Here, it is given that if Machine B is purchased for $900,000 there will be saving of 20% over the current machine used. So, here we have to compare that if we invest $900,000 how total cost will be saved in future. Year Value 1 2 Present Value Present Cost for Current Machine Saving @20% Factor @ 12% 1,000,000.00 200,000.00 0.89 178,571.43 1,350,000.00 270,000.00 0.80 215,242.35 1,400,000.00 280,000.00 0.71 199,298.47 1,450,000.00 290,000.00 0.64 184,300.24 2,550,000.00 510,000.00 0.57 289,387.70 3 4 5 Total Present Value of Saving 1,066,800.18 Less : Initial Investment (900,000.00) NPV 166,800.18 From, the above calculation we can see that, If $500,000 invested today, present value of Future Benefits will be $33,400.09. If $900,000 invested today, present value of Future Benefits will be $166,800.18. Thus, it is advisable for MKM International to go for Machine B, as it is having higher NPV.