Question

The Kentucky Bourbon Company is considering adding processing equipment to the plant to aid in the removal of impurities from some raw materials. By adding the processing equipment, the firm can purchase lower-grade raw material at reduced cost and upgrade it for use in its products. Four pieces of processing equipment are being considered. The company can obtain a 12% annual return on its investment in other projects and is willing to invest money in the processing equipment only as long as it can obtain 12% annual return on each increment of money invested. Which one, if any, of the alternatives should be selected? Use the challenger-defender rate of return analysis assuming perpetual or indefinite life.

	Machine A	Machine B	Machine C	Machine D
Initial Investment	$ 12,000	$ 20,000	$ 26,000	$ 33,000
Annual Savings in Material Costs	$ 4,000	$ 6,000	$ 8,000	$ 10,000
Annual Operating Costs	$ 2,000	$ 3,000	$ 4,000	$ 5,000

Answer 1

Let the rate of return = r

time period = infinite

Machine A:

Initial investment = PV of net savings (discounted at the rate of return)

Net savings = 4000 - 2000 = $2000

12000 = 2000/r

r = 16.67%

Machine B:

Net savings = 6000 - 3000 = $3000

20000 = 3000/r

r = 15%

Machine C:

Net savings = 8000 - 4000 = $4000

26000 = 4000/r

r = 15.38%

Machine D:

Net savings = 10000 - 5000 = $5000

33000 = 5000/r

r = 15.15%

Machine A has the highest rate of return among all alternatives (16.67% > 12% MARR) and hence it must be chosen