Suppose that ABC Ltd is considering purchasing one of three new processing machines. Either machine would make it possible for the company to produce its products more efficiently. Estimates regarding each machine are provided below: Machine A Machine B Machine C Original cost $79,000 $110,000 $244,000 Estimated life 7 years 8 years 10 years Salvage value Nil Nil $30,000 Estimated annual cash inflows $30,000 $ 60,000 $58,500 Estimated annual cash outflows $ 7,000 $ 35,000 $18,500 A. If the projects cannot be repeated, which machine should ABC Ltd choose based on the NPV criteria at an 8% cost of capital? (9 marks) B. If the projects can be repeated, which machine should ABC Ltd choose based on the NPV criteria at an 8% cost of capital? (6 marks) C. Calculate the internal rate of return for Machine A? [Hint: internal rate of return is the rate which results in a zero NPV using linear interpolation], and discuss 1 drawback of the IRR against the NPV (5 marks)
Answers
Suppose that ABC Ltd is considering purchasing one of three new processing machines. Either machine would make it possible for the company to produce its products more efficiently. Estimates regarding each machine are provided below: Machine A Machine B Machine C Original cost $79,000 $110,000 $244,000 Estimated life 7 years 8 years 10 years Salvage value Nil Nil $30,000 Estimated annual cash inflows $30,000 $ 60,000 $58,500 Estimated annual cash outflows $ 7,000 $ 35,000 $18,500 A. If the projects cannot be repeated, which machine should ABC Ltd choose based on the NPV criteria at an 8% cost of capital? (9 marks) B. If the projects can be repeated, which machine should ABC Ltd choose based on the NPV criteria at an 8% cost of capital? (6 marks) C. Calculate the internal rate of return for Machine A? [Hint: internal rate of return is the rate which results in a zero NPV using linear interpolation], and discuss 1 drawback of the IRR against the NPV (5 marks)
Step-by-step explanation:
Machine to consider
Net Present Value (NPV)
Machine A
NPV = - I.O / (1+r)n + NCF /(1+r)ⁿ
NPV = - 79,000 / (1+0.08)0 + Net Cashflow (NCF) /(1+0.08)⁷
NPV = - 79,000 / (1.08)0 + NCF/ (1.08)⁷
Machine B
NPV = - I.O / (1+r)n + NCF /(1+r)ⁿ
NPV = - 110,000 / (1+0.08)0 + Net Cashflow (NCF) /(1+0.08)⁸
NPV = - 110,000 / (1.08)0 + NCF/ (1.08)⁸
NPV = - I.O / (1+r)n + NCF /(1+r)n
NPV = - 110,000 / (1+0.08)⁰ + Net Cashflow (NCF) /(1+0.08)ⁿ+ Net Cashflow (NCF)+Terminal Value /(1+0.08)¹⁰
From the analysis, machines A should be selected since it has the highest NPV of 40,746.51.
B). If machines can be repeated
Machine B should be considered since it has a higher payback on NPV based on the NPV and initial cost/outlay.
C). IRR & NPV
IRRA = 18%
NPVA = $ 40,746.51
Decision criteria
Based on the NPV, machine A should be the most suitable.
Based on the internal rate of return (IRR), machine A should be the most suitable since it is greater than the cost of capital (8%).
Disadvantage of IRR over NPV
The internal rate of return (IRR) does not account for the size of the project it also ignores the futures costs and also it doesn't account for the reinvestment rates. It is not very suitable when considering more than a single project.