Question

Old Southwest Canning Co. has determined that any one of four machines can be used in its chili-canning operation. The cost of the machines are estimated below, and all machines have a 5-year life. If the minimum attractive rate of return is 25% per year, determine which machine should be selected on the basis of a rate of return analysis.

Machine	First Cost, $	AOC, $
1	−28,000	−20,000
2	−51,000	−12,000
3	−32,000	−19,000
4	−33,000	−18,000

Which machine should be selected?

Answer 1

MARR = 25%

We need to do incremental IRR analysis

In order to calculate incremental IRR, first, we arrange the options in the increasing value of their initial cost

We need to find incremental cash flow between lowest and second lowest option first, then use the formula of IRR in excel on the incremental cash flow, if incremental IRR is greater than MARR then select the second lowest option if it is less than the MARR then select the lowest option.

Keep repeating the above until the last option is evaluated

	Machine				Incremental IRR Analysis
Year	1	3	4	2	3-1	4-1	2-4
0	-28000	-32000	-33000	-51000	-4000	-5000	-18000
1	-20000	-19000	-18000	-12000	1000	2000	6000
2	-20000	-19000	-18000	-12000	1000	2000	6000
3	-20000	-19000	-18000	-12000	1000	2000	6000
4	-20000	-19000	-18000	-12000	1000	2000	6000
5	-20000	-19000	-18000	-12000	1000	2000	6000
	Incremental IRR				7.93%	28.65%	19.86%

We compare first Machine 3 and machine 1 since machine 1 has the lowest cost, and the second lowest option is machine 3, incremental IRR is less than MARR so we select machine 1, and machine 3

Now we find incremental cash flow between machine 4 & machine 1, we find incremental IRR>MARR, so we select machine 4 and reject machine 1

Now we find incremental cash flow between machine 2 & machine 4, we find incremental IRR<MARR, so we select machine 4 again and reject machine 2

Machine 4 should be selected as per the incremental IRR analysis

Pls comment if you require any further explanation