Question

The Big Company is considering the following investment alternatives with the objective of increasing sales of Product P. You have been asked to evaluate each option:

Investment A: Purchase new machinery with the capacity to increase production of Product P. The machine will cost $501,000 and Big has experience with this type of equipment. Given that this investment is considered to have a reasonably low risk associated with it, the company appropriately selected a 6% required rate of return (discount rate).

Investment B: Purchase new machinery that is also believed to have the capacity to increase production of Product P. This machine will cost $520,000. This type of machinery uses new technology that has not been fully tested so there are some concerns about its actual productivity. The company chose an 8% required rate of return (discount rate).

Investment C: Purchase new machinery that is also believed to have the capacity to increase production, but again, there is concern that the new technology that this machine uses has not been fully tested. This machine will cost $525,000. However, instead of producing Product P, Big would enter a new market by producing Product Q. Big has little familiarity with marketing Product Q. The company chose a 10% required rate of return (discount rate).

  

	Projected annual cash inflows associated with each Investment option
Year	Investment A	Investment B	Investment C
Required Rate of Return	6%	8%	10%
Annual cash inflows	$ 119,000	$116,000	$106,000
Number of years cash flow is expected	5	6	8

Your case analysis should be presented in a report format with the following parts:

What do you recommend? For each method (payback, net present value, and internal rate of return) identify whether the investment is acceptable or not.

Answer 1

		Investment A	Investment B	Investment C
	Initial investment	$           5,01,000	$           5,20,000	$            5,25,000
	Annual cash inflows	$           1,19,000	$           1,16,000	$            1,06,000
	Life in years	5	6	8
	Required rate of return	6%	8%	10%
a]	Payback period in years [Initial investment/Annual cash inflows]	4.21	4.48	4.95
	No maximum permissible payback is prescribed. As all the investments have payback less
	than their useful lives, all of them can be accepted.
b]	PVIFA	4.21236	4.62288	5.33493
	PV of annual cash inflows	$           5,01,271	$           5,36,254	$            5,65,502
	Less: Initial investment	$           5,01,000	$           5,20,000	$            5,25,000
	NPV	$                     271	$               16,254	$               40,502
	All the projects are acceptable as their NPVs are positive.
c]	IRR:
	IRR is that discount rate for which NPV is 0.
	Initial investment/Annual cash inflow = PVIFA(irr,n) =	4.2101	4.4828	4.9528
	Investment A:
	The interest factor for n = 5 and r = 6% =	4.2124
	The interest factor for n = 5 and r = 7% =	4.1002
	By simple interpolation IRR = 6%+1%*(4.2124-4.2101)/(4.2124-4.1002) =	6.02%
	Investment B:
	The interest factor for n = 6 and r = 9% =		4.4859
	The interest factor for n = 6 and r = 10% =		4.3553
	By simple interpolation IRR = 9%+1%*(4.4859-4.4828)/(4.4859-4.3553) =		9.02%
	Investment C:
	The interest factor for n = 8 and r = 12% =			4.9676
	The interest factor for n = 6 and r = 13% =			4.7988
	By simple interpolation IRR = 12%+1%*(4.9676-4.9528)/(4.9676-4.7988) =			12.09%
	All the projects are acceptable as their IRRs are greater than their individual discount rate.