Question

Question:
On the Level Construction Company has been growing and needs to purchase a new machine. They have been researching multiple companies and have narrowed down their choices to two options - based on reliability and customer service. They now need the help of accounting to determine which option is better financially.

Company 1 - Millipede

The equipment would cost $3,000,000 up front.

It has a 12 year useful life.

Millipede's equipment would allow for 2 additional construction jobs per year.

Company 2 - Jack Moose

The equipment would cost $4,000,000 up front.

It has a 10 year useful life.

Jack Moose's equipment would allow for 3 additional construction jobs per year.

Each construction job requires a certain number of machines, and On the Level has determined that each additional construction job for the year would generate an additional $300,000 in Revenue. Because they receive their income after the job is complete, assume revenue is received at the end of each year. On the Level's expected annual rate of return is 11%

Questions: 

1)     Using either NPV or IRR (your choice), calculate NPV or IRR for each equipment option.

2)    Why you chose either NPV or IRR.

3)     Explain which investment the company should choose and the justification for that decision.

4)     Calculate ROI for both investments.

5)     Calculated expected annual ROI for both investments.

6)     Would On the Level make the same decision if they used ROI for their investment analysis? What are the differences between the calculations?

7)     A few years after purchasing the equipment, On the Level realizes that the new equipment is only generating an additional $250,000 in Revenue per year. How does this impact the NPV/IRR and ROI calculations and their decision? Did they make the right decision?

8)     Explain how a company can take into account items that are uncertain when making investment decisions.

Answer 1

Note: It has been assumed that there is no tax in the economy, thus tax benefit on depreciation ahs been ignored.

If company 1 is selected:

Present Value of outflow: $3000000

Present Value of Inflow @ 11% for 12 years: 3895414

Net Present Value: 895414

Eqiutated NPV: 895414/(1.11)¹²= 137918

If company 2 is selected:

Present Value of Outlow: $4000000

Present Value of Inflow for 10 years @ 11%: 5300309

NPV: 1300309

Eqiutated NPV: 1300309/(1.11)¹⁰= 220794

Decision: It is better to select company 2.

ROI for Investment 1:

600000/3000000= 20%

ROI for Investment 2:

900000/4000000= 22.5%

If the company make the decision on the basis of ROI, then it will not be correct as in the ROI concept, the present value of the money is ignored.