Easton Ltd needs to purchase a machine to manufacture a new product. The choice lies between two machines (A and B). Each machine has an estimated life of three years with no expected scrap value.

Machine A will cost £15,000 and Machine B will cost £20,000, payable immediately in each case. The total variable costs of manufacture of each unit are £1 if made on Machine A, but only £0.50 if made on Machine B. This is because Machine B is more sophisticated and requires less labour to operate it.

The product will sell for £4 per unit. The demand for the product is uncertain but is estimated at 2,000 units for each year, 3,000 units for each year or 5,000 units for each year.

(Note that whatever sales volume level actually occurs, that level will apply to each of the three years.)

The sales manager has placed probabilities on the level of demand as follows:

Annual demand Probability of occurrence 2,000 0.2 3,000 0.6 5,000 0.2 Assume that both taxation and fixed costs will be unaffected by any decision made.

Easton Ltd’s cost of capital is 6 per cent per year.

Required:

(a) Calculate the NPV for each of the three activity levels for each machine, A and B, and, using those results, calculate the expected NPV for each machine.

(b) What advice would you give the business in selecting between the two machines?

Intermediate-level exercises AppendixLO1