Question

Question 4

Unicom International is interested in purchasing a machine producing widgets. Assume that the machine the company is interested in costs £20,000,000, and that it is estimated to generate a cash inflow of £22,000,000 at the end of the next year. The effective discount rate for the machine is equal to 8% per annum.
i) Use the internal rate of return (IRR) rule to determine whether or not Unicom International should purchase the widget machine.

ii) Show that, in this case, the company’s decision would have been identical if it had used the net present value (NPV) rule.
iii) Now assume that the company incurs costs of £1,000,000 to dispose of the widget machine at the end of the second year. Discuss why in this case the internal rate of return (IRR) rule can no longer be used (no calculations required). How should the company in this case evaluate whether or not to invest into the widget machine?
b) Assume that, in addition to the machine discussed in question 11a), there is also a “premium” alternative. The cost of the premium widget machine is equal to £36,000,000, but the premium machine generates cash inflows of £22,000,000 over the next two years (with the cash inflows again occurring at the end of each year). The effective discount rate is again equal to 8%.
Use the incremental internal rate of return (IRR) rule to determine which of the two machines the company should invest in.

Please, type it, as it is hard to understand handwriting.

Answer 1

i)	IRR = 22000000/20000000 -1 =	10.00%
	As the IRR is greater than the effective discount rate, the
	Widget machine should be purchased.
ii)	NPV = 22000000/1.08-20000000 =	$   3,70,370
	The Widget machine should be purchased as the NPV is
	positive. The decision is the same.
iii)	The cash ouflow (negative) at the end of year 2 may give
	rise to multiple IRRs, as the positive and negative cash
	flows occur alternatingly. Decision making will be difficult.
	The proper method in such a case is the NPV. Which is
	NPV = 22000000/1.08-1000000/1.08^2-20000000 =	$ -4,86,968
	As the NPV is negative, the machine should not be
	purchased.
b)	Incremental investment = 36000000-20000000 =	16000000
	Incremental cash flow in year 1 = 22000000-22000000 =	0
	Incremental cash flow in year 2 =	22000000
	Incremental IRR = (22000000/16000000)^(1/2)-1 =	17.26%
	As the incremental IRR is more than the effective discount rate, the
	premium machine is preferable.