Question

Question 3

Al Burami plc has a subsidiary that is requesting for additional cash injection to purchase a machinery. The forecasted cash flows of the machinery over the next 5 years are as follow:-

Year	Cashflow OMR	DCF @ 10%	DCF @ 20%
0	(20,200)	1.000	1.000
1	6,700	0.909	0.833
2	6,700	0.826	0.694
3	6,700	0.751	0.579
4	6,700	0.683	0.482
5	6,700	0.621	0.402

Required:-

Write a management report to the Managing Director of AL Burami plc, on whether they should provide the subsidiary with additional cash to invest in the machinery. The cost of capital is 10%. Your report should include, inter alia:-

1. The use of the Payback, NPV and IRR techniques as part of your investment appraisal;
2. All your calculations are to be shown clearly;

3. A critical discussion of which investment appraisal technique is the most appropriate;

4. Any other information you may require.

Formula.

Approx. IRR = R1 + NPV1 × (R2 – R1)

                                    (NPV1 – NPV2)

Answer 1

Managing Director,

AL Burami plc,

Dear Sir,

Reg: Evaluation of an investment requirement in a machinery for our Subsidiar Company

An initial outlay of 20,200 is required for investment in a machinery which will give annual inflow of 6,700 for next 5 years. Cost of capital is 10%.

After going through various investment appraisal technique we have observed as under:

A. Pay back period method technique:

Year Cash Flow DCF@10% Discounted cash flow

0 (20,200) 1.000 (20,200)

1 6,700 0.909 6090.30

2 6,700 0.826 5534.20

3 6,700 0.751 5031.70

4 6,700 0.683 4576.10

5 6,700 0.621 4160.70

Total inflow of initial 3 years are 6090.30+5534.20+5031.70=16656.20 which is 3543.80 short of our initial outlay of 20,200.

4th year inflow is 4576.10 hence we need full 3 years and some part of 4th year to get back our initial investment of 20,200

Pay back period=3 years + 3543.80/4576.10 years

=3 years + 0.77 years

=3.77 years

Hence we will get back our initial investment in 3.77 years which is well below the 5 years for which we are planning to investement.

Hence we may consider this investement option.

B. NPV Technique:

NPV is calculated by additing present value of all inflows - present value of initial outlay

In continuation of above calculation, PV of all inflows are 6090.30+5534.20+5031.70+4576.10+4160.70=25,393

PV of outlay is 20,200

Hence NPV is 25,393-20,200=5,193

As evindent from above we are getting positive NPV of 5,193 from the invesment in machinery hence we should go for the investment decision.

C. IRR technique:

The internal rate of return is a discount rate that makes the net present value (NPV) of all cash flows equal to zero in a discounted cash flow analysis.

NPV = FV0/(1+r)^0 + FV1/(1+r)^1 + FV2/(1+r)^2 + FV3/(1+r)^3 +  FV4/(1+r)^4 +  FV5/(1+r)^5

0 = (20,200)/(1+r)^0 + 6,700/(1+r)^1 + 6,700/(1+r)^2 + 6,700/(1+r)^3 + 6,700/(1+r)^4 +   6,700/(1+r)^5

By trial and error method we get IRR of 20%.

We get IRR of  20% against the cost of capital of 10%, hence we should go for the investment decision in machinery.

IRR method is most appropriate as it provides as annual return of an investment which may be compared with other avenues to compare.

Thanking You