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Homework answers / question archive / Advanced Engineering (Pty) Ltd needs to replace one of the profile cutters in its factory with a computer-operated profile cutter
Advanced Engineering (Pty) Ltd needs to replace one of the profile cutters in its factory with a computer-operated profile cutter. Alfred, the factory manager, identified a replacement profile cutter and prepared the following information for management to consider: Year Net cash flows 1 140 000 2 120 000 3 95 000 4 70 000 5 50 000 The initial required investment is R325 000 and the company's cost of capital is 13%. Alfred calculated the net present value (NPV) of the investment as R28 755. The financial manager, however, requested that Alfred also calculate the internal rate of return (IRR) for this project before tabling the information for decision-making. The financial manager instructed Alfred to use an alternative cost of capital of 18% for his calculations. Required: Note: Show all your calculations and round off all calculations to the nearest whole number. 3.1. Use the information provided to calculate the internal rate of return (IRR) of this proposed investment (20) 3.2. Should the company invest in this profile cutter based on Alfred's NPV and IRR calculations? Substantiate your answer based on relevant decision criteria.
Answer of part 3.1 - Calculation of Internal Rate of Return of given proposed investment :-
Step 1: Select discount rates for the calculation of NPVs,we can take 13% (R1) and 18 % (R2) as our discount rates already given in question.
Step 2: Calculate NPVs of the investment using the discount rates.As NPV @ 13% discount rate is given.i.e.Rs.28,755,we have to calculate NPV @ 18 % only for calculation of IRR.
Net Present Value @ 18
Years Cash Flows Discounting Factor @ 18% Present value of Discounted Cash Flows
0 (325,000) 1.000 (325,000)
1 140,000 0.847 118,580
2 120,000 0.718 86,160
3 95,000 0.609 57,855
4 70,000 0.516 36,120
5 50,000 0.437 21,850
NPV of Dis.Cash flows(320,565 - 325,000) - 4435
Step 3: Calculation the IRR
= R1% + [(NPV1 x (R2 – R1)%) ÷ (NPV1 – NPV2)]
= 13% + [(28,755 x (18 – 13)%) ÷ (28,755 – (- 4,435))]
= 13% + [(28,755 x 05%) ÷ (28,755 + 4,435)]
= 13% + (1437.75 / 33190)*100
= 13% + 4.33%
= 17.33%
Therefore,IRR is 17.33%.
Answer of part 3.2: Interpretation
The investment should not be accepted by the company,because the cost of capital (i.e. 18%) is more than the IRR of 17.33%.Also,the NPV of proposed investment is negative.i.e.- 4,435 which makes the proposed investment financially nonviable.
NOTE :- Decision of the above problem is based on keeping in mind that company's Cost of capital is 18%.If we take 13% cost of capital then decision of the proposed investment is changed as that time cost of capital (i.e. 13%) is lower than the IRR of 17.33%.Also,the NPV of proposed investment is .i.e. 28,755 which makes the proposed investment financially viable.
