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Recommend to management which investment should be made and why
Approach: In this question you are not given the initial investment required for each of the asset types. This is calculated by adding the total depreciation charged over the life and as the assets are expected to have a residual value of zero this adds to the original cost of the assets.
i. The payback method.
New Age |
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Year |
Cash flow |
Cum C/F |
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0 |
-47,500 |
-47,500 |
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1 |
10,000 |
-37,500 |
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2 |
11,000 |
-26,500 |
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3 |
18,000 |
-8,500 |
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4 |
16,200 |
7,700 |
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5 |
10,000 |
17,700 |
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Payback |
3 years + (8500/16200 x 12) |
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3 years 6.3 |
months |
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Standard Equipment |
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Calculation of relevant cash flows |
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|
Year |
Cash flow |
Cum C/F |
|
|
0 |
-30,000 |
-30,000 |
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1 |
4,000 |
-26,000 |
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2 |
7,500 |
-18,500 |
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|
3 |
13,200 |
-5,300 |
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4 |
8,400 |
3,100 |
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5 |
4,000 |
7,100 |
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Payback |
3 years + (5300/8400 x 12) |
|
3 years + 7.57 months |
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ii. The net present value method.
New Age |
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Year |
Cash flow |
Disc 10% |
P.V. |
|
|
0 |
-47,500 |
1 |
-47500 |
|
|
1 |
10,000 |
0.909 |
9090 |
|
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2 |
11,000 |
0.826 |
9086 |
|
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3 |
18,000 |
0.751 |
13518 |
|
|
4 |
16,200 |
0.683 |
11064.6 |
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|
5 |
10,000 |
0.621 |
6210 |
|
|
|
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|
1468.6 |
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Standard Equipment |
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|
Year |
Cash flow |
Disc 10% |
P.V. |
|
|
0 |
-30,000 |
1 |
-30000 |
|
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1 |
4,000 |
0.909 |
3636 |
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2 |
7,500 |
0.826 |
6195 |
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3 |
13,200 |
0.751 |
9913.2 |
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4 |
8,400 |
0.683 |
5737.2 |
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|
5 |
4,000 |
0.621 |
2484 |
|
|
|
|
|
-2034.6 |
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iii. The internal rate of return method.
New Age |
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Year |
Cash flow |
Disc 10% |
P.V. |
Disc 15% |
P.V. |
|
|
|
0 |
-47,500 |
1 |
-47500 |
1 |
-47500 |
|
|
|
1 |
10,000 |
0.909 |
9090 |
0.87 |
8700 |
|
|
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2 |
11,000 |
0.826 |
9086 |
0.756 |
8316 |
|
|
|
3 |
18,000 |
0.751 |
13518 |
0.658 |
11844 |
|
|
|
4 |
16,200 |
0.683 |
11064.6 |
0.572 |
9266.4 |
|
|
|
5 |
10,000 |
0.621 |
6210 |
0.497 |
4970 |
|
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|
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|
1468.6 |
|
-4403.6 |
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IRR |
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|
10 + (1468.6/1468.6+4403.6) x 10-15 |
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|
11.25% |
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Standard Equipment |
|
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|
|
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|
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|
Year |
Cash flow |
Disc 10% |
P.V. |
Disc 3% |
P.V. |
|
|
|
0 |
-30,000 |
1 |
-30000 |
1 |
-30000 |
|
|
|
1 |
4,000 |
0.909 |
3636 |
0.971 |
3884 |
|
|
|
2 |
7,500 |
0.826 |
6195 |
0.943 |
7072.5 |
|
|
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3 |
13,200 |
0.751 |
9913.2 |
0.915 |
12078 |
|
|
|
4 |
8,400 |
0.683 |
5737.2 |
0.888 |
7459.2 |
|
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5 |
4,000 |
0.621 |
2484 |
0.863 |
3452 |
|
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|
-2034.6 |
|
3945.7 |
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IRR |
3 + (3945.7/3945.7+2034.6) x 10-3 7.62% |
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Based on the various appraisal techniques the company should invest in the new age equipment. The reasons are as follows
- The payback period is slightly less for the new age investment
- More importantly the NPV of the new age investment is positive whereas the NPV for the standard equipment is negative. Thus the present value of the cash inflows exceed the present value of the cash outflows for the new age investment whereas the opposite is expected to occur for the standard equipment.
- The IRR for the new age investment is above the cost of capital for the business whereas the IRR for the standard equipment is below the cost of capital or minimum required return for the business
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