Problem 1: Internal Rate of Return
Your firm is considering overhauling its production plant. The finance department in consultation with the engineering department has come up with two proposals, one for a minor overhaul and one for a major overhaul. These two proposals have the following cashflows
The cost of capital for these projects is 12%. If your firm follows the Internal Rate of Return (IRR) in making all investment decisions, which proposal do you think your firm should accept? Please show detailed workings/calculations and an explanation of your recommendation.
Problem 2: Projects with different costs and lives
Mr. Butler runs a lawnmowing business. Recently his manager Ms. Natalie reported that one of the mowers has to be replaced. After analyzing the prices of different mowers, Ms. Natalie finally came up with two options:
- Option 1: Mower A costs $250 and is expected to last 2 years
- Option 2: Mower B costs $360 and is expected to last 3 years
Mr. Butler instructed Ms. Natalie to purchase mower B since its investment is $360/3 = $120 per year, which is lower than the investment of $250/2 = $125 per year in mower A. Ms. Natalie purchased mower B and replaced the old one. Did Mr. Butler take the correct decision? Explain your answer with detailed workings/calculations. Assume 10% cost of capital.
Problem 3: Comprehensive capital budgeting
Flemingo Inc. purchased a special machine 1 year ago at a cost of $12,000. At the time of purchase, the machine was estimated to have a useful life of 6 years and no salvage value. The annual cash operating cost is approximately $20,000.
A new machine has just come on the market which will do the same job but with an annual cash operating cost of only $17,000. This new machine costs $21,000 and has an estimated life of 5 years with zero salvage value. The old machine can be sold for $10,000 to a scrap dealer. Straight-line depreciation is used, and the company’s income tax rate is 40 percent.
Assuming a cost of capital of 8 percent after taxes, calculate
(a) Loss or gain on the sale of an old machine
(b) The initial investment
(c) The incremental cash inflow after tax
(d) The NPV of the new investment, and
(e) The IRR on the new investment
(f) What decision can be made from your answer in (c) and (d) above?
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