Question

Machalo Limited is a fashion company. Michael, one of the ‘bright young things’ who works in the design department, has come up with a new style of a T-shirt – the D’urberville. The product is not expected to have a long sales run but will be popular whilst it lasts.
Two methods of promoting the T-shirt are available:
Method 1: ‘swamping the market’ – this would involve an initial advertising campaign costing K100,000 and would result in net cash inflows after one year of K230,000. However, commission of K132,000 would have to be paid one year after the inflows.
Method 2: waiting for the market to develop gradually. This would involve an initial advertising campaign costing K70,000 and would result in net cash inflows of zero after one year and K38,000 at the end of each of the subsequent three years.
Mrs Kangwa, a director of Machalo Limited, has commented: ‘Method 1 can’t be acceptable since the net receipts of K230,000 are less than the total outflows of K232,000. Method 2 can’t be adopted since the expense of K70,000 in a year with no revenue to show for it will mean that we won’t have enough money to pay the dividend which our shareholders require.’
Machalo Limited’s cost of capital is 15%. The directors do not expect capital to be in short supply during the next four years.
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Required:
a) Calculate the net present values and estimate the internal rates of return of the two methods of promoting the new product.
b) Advise the directors of Machalo Limited which method they should adopt, explaining the reasons for your advice and noting any additional information you think would be helpful in making the decision.
c) Comment on the views expressed by Mrs Kangwa.

Answer 1

a)Outflow

100000 Initial otflow,

after two year outflow is 132000.

Inflow is 230,000 after 1 year.

Pv of outflow is=100000+(132000/1.15^2)

199810.96

Pv of inflow is 230000/1.15=200000

Hence NPV=200000-199810.96

189.04.

IRR for method 1

outflow	Inflow	Pv@15%	Pvof I/F	Pv req
100000				100000
	230000	0.869	199870
132000		0.756		99792
			199870	Total=199792

Outflow	inflow	Pv@14%	Pv of I/F	PV req
100000				100000
	230000	0.877	201,710
132000		0.769		101508
				Total=201508

Using intrapolation formula=

Lower rate+(Pv@ lr-PV Required)/(PV@LR-PV@HR)(HR-LR)

14+(201710-201508)/(201710-199870)= 14.12%

Method 2

IRR

Let us take 17% at first.

Outflow	Inflow	Pv @17%	PVof inflows	PV@18%	PV of Inflows
70000		-		-	-
1	0	0.855		0.847	-
2	38000	0.731	27778	0.718	27284
3	38000	0.624	23712	0.609	23142
4	38000	0.534	20292=SUMofabove71782	0.516	19608

PV@17%=71782 PV@18%=70034

Using Intrapolation equation.find IRR

Lower rate+(PV@lower rate -PV required)/(PV@Lower rate -PV@ higher rate)

17+(71782-70000)/(71782-70034)=17.67%

NPV in method 2

PV@15% for 1 year=0.869, for 1st year Pv of inflow is zero for 2nd year onwards

38000	0.756	28728
38000	0.656	24928
38000	0.572	21736

Pv of cash inflow=75392.

NPV=75392-70000=5392.

b)NPV of 1st method=189.04 and 2nd is 5392.

IRR for 1st method is 14.12% and 2nd is 17.67%

In both the case method 2 is giving better result.

But these are projects with unequal lives. project a is only for 1 year and project 2 is for 3 years.That's why these two methods cant be compared.

c)Mrs kangwa dint not consider time value of the money and heence directly compared costs with benefits and arrived at the decision to compare .and in project 2 kangwa said that for first year no revenue but he has not taken that for next 3 years the project is giving a positive revenue.