Question

XYZ is a company located in Italy, the company manufactures machine parts. It is currently involved in making a decision concerning the acquisition of new machining tool. Two different versions of the tool are available: X AND Y. The forecasted cash flows of the two alternative are listed below; XYZ normally uses payback with a 3-year criterion. NET CASH FLOWS ($000s) Tool X Year 0 -1000, Year 1 +400, Year 2 +600, Year 3 +187, Tool Y Year 0 -450, Year 1+300, Year 2+150, Year 3+106. XYZ faces a perfect capital market, in which the interest rate for the projects' risk level is 5%. Required: (a) Using the Payback and the IRR decisions rule, indicate which projects the company should accept and state clearly the reasons for your decisions. (b) How would your conclusions in (a) will change if the projects were mutually exclusive? (c) State clearly any limitations and assumptions that you made in your calculations.

Answer 1

a)

Tool X
Year 0: -1000,

Year 1 : +400,

Year 2 : +600,

Year 3 : +187

Initial investment = -1000

year 1 income = 400

remaining investment to get = 600

year 2 income = 600

so totally it took 2 years to get back the initial investment

Similarily for TOOL Y

Year 0 -450, Year 1+300, Year 2+150, Year 3+106.

It takes 2 years to get back the initial investment of 450

So both these projects are within the 3-years both can be accepted as it is independent project

IRR for TOOL X

we can use the financial calculator

Press CF

CF0 = -1000

C01 = 400

F01 = 1

C02 = 600

F02=1

C03=187

F03=1

Press IRR and then Press CPT

we get IRR as 10%

IRR for TOOL Y

Press CF

CF0 = -450

C01 = 300

F01 = 1

C02 = 150

F02=1

C03=106

F03=1

Press IRR and then Press CPT

we get IRR as 14.02%

Since both are independent projects and both have IRR greater than cost of capital 5%

Both can be accepted

b)

When both are mutually exclusive projects,

payback is same for both X and Y

But IRR for Tool Y is greater than that of Tool X

hence we can choose Tool Y.

c)

Both IRR and Payback is not a clear way to select a project, as it creates many ambiguities.

IRR can result is multiple values if the cash flows are positive and negetive.

• The IRR is a useful valuation measure when analyzing individual capital budgeting projects, not those which are mutually exclusive.
• Pay back period does not take time value of money into account

In order to select the project most ideal and superior method is NPV method.