Polly plc is considering the purchase of two alternative machines. The purchase
ID: 2795209 • Letter: P
Question
Polly plc is considering the purchase of two alternative machines. The purchase of either will increase production. The purchase price of machine ‘A’ is £12,000 and the estimated cash flows from the machine are as follows:
Year 1 2 3
Cash flow (£) 8,400 3,000 3,000
Machine ‘A’ also has disposal value of £1,500. The purchase price of machine ‘B’ is £30,000 and the estimated cash flows from the machine are as follows:
Year 1 2 3
Cash flow (£) 10,000 10,000 20,000
Machine ‘B’ also has a disposal value of £5,000.
Calculate the Internal Rate of Return, Payback Period, the Net Present Value and the Accounting Rate of Return for both investments. The appropriate discount rate is 12%. Both machines will be depreciated by the straight line method over 3 years. On the basis of your results indicate which machine you recommend Polly plc purchase.
Explanation / Answer
(a) Machine A - (i) NPV = Years 0 1 2 3 Initial investment -12000 Cash flows 8400 3000 3000 Total cash flows -12000 8400 3000 3000 1 PV factors 1 0.892857 0.797194 0.71178 PV of cash flows -12000 7500 2391.582 2135.341 NPV = 26.92238 (ii) Payback period = Year cash flows Cumulative cash flows 0 -12000 0 1 8400 8400 2 3000 11400 3 3000 14400 Payback period = 2 + [(12000-11400)/3000) = 2 + (600/3000) = 2.2 years (iii) IRR = if we discount cash flows @ IRR NPV = 0 r= NPV = 12% 26.92238 r 0 13% -137.781 r-12/13-12 (0-26.92)/(-137.78-26.92) r-12 = 0.1635 X 1 r = 0.1635 r = 12.1635 (%) Approx (iv) Accounting rate of return - Annual depreciation = (12000 - 1500)/3 =3500 Years 0 1 2 3 Initial investment -12000 Cash flows 8400 3000 3000 Less: Depreciation - 3500 3500 3500 4900 -500 -500 total profit for 3 years = 4900 -500 -500 = 3900 Average profit = 3900/3 = 1300 Average investment = 12000/3 = 4000 Accounting ROR = Average Profit/ average investment x 100 = = 1300/4000 x 100 = 32.5 (b) Machine B - (i) NPV = Years 0 1 2 3 Initial investment -30000 Cash flows 10000 10000 20000 Total cash flows -30000 10000 10000 20000 1 PV factors 1 0.892857 0.797194 0.71178 PV of cash flows -30000 8928.571 7971.939 14235.6 NPV = 1136.115 (ii) Payback period = Year cash flows Cumulative cash flows 0 -30000 0 1 10000 10000 2 10000 20000 3 20000 40000 Payback period = 2 + [(30000-20000)/20000] = 2 + (10000/20000) = 2.5 years (iii) IRR = if we discount cash flows @ IRR NPV = 0 r= NPV = 12% 1136.115 r 0 14% -33.9646 r-12/14-12 (0-1136.115)/(-33.965 - 1136.115) r-12 = 0.971 X 2 r = 1.942 + 12 r = 13.9419 (%) Approx (iv) Accounting rate of return - Annual depreciation = (30000-5000)/3 = 8333.333 Years 0 1 2 3 Initial investment -30000 Cash flows 10000 10000 20000 Less: Depreciation - 8333.333 8333.333 8333.333 1666.667 1666.667 11666.67 total profit for 3 years = 1666.67+1666.67+11666.67 = 15000 Average profit = 15000/3 5000 Average investment = 30000/3 10000 Accounting ROR = Average Profit/ average investment x 100 = = 5000/10000 X 100 50 (c ) Decision - Criteria Machine A Machine B Remarks NPV (Higher) 26.92238 1136.115 Machine B (Higher NPV) Payback Period (Lower) 2.2 Years 2.5 Years Machine A (Lower Payback) IRR (Hiigher) 12.1635 13.9419 Machine B (Higher IRR) AROR (Higher) 32.5 50 Machine B (Higher AROR) AS machine B Is better with 3 criterias it should be selected. Please provide feedback……... thanks in advance……… :-)