Question

The company "ABCD" is considering to make a new investment by purchasing a new machine for the production of a new product. For the new machine, "ABCD" must spend 6,000 euros, which will be sold after six years. Each year, the machine has 200 euros operating costs. The beneficial/useful life span of the machine is 6 years and its residual (salvage) value is zero.

YEAR	INCOME THE MACHINE GENERATES (in euros)
1	800
2	1,200
3	1,800
4	2,700
5	3,000
6	1,500
TOTAL	11,000

In addition, the corporate tax rate is 40%. the capital cost factor is 8% and the company applies the straight-line method in calculating depreciation.

Evaluate the investment by using:

a) net present value (NPV) method

b) internal rate of return (IRR) method

Discuss your results.

Answer 1

NPV : Net Present Value (NPV) is the method of finding difference between present value of cash outflows and cash inflows where cashflows are discounted at rewuired rate of return which may project or companies cost of capital etc.

1. Calculation of NPV of the Project :

2. Calculation of IRR of the Project :

IRR: Internal Rate of Return (IRR) is the method of finding out the rate which equals cash inflows and outflows i.e, NPV will becomes zero at IRR.

• Cash flow after tax calculated above is used in IRR calculation.

Note : IRR is calculated using Excel Function IRR or it can also be solved thorugh trial and error method.

Results :

1. NPV of the machine is positive 196.42 which means the machine is providing more than the required rate of return i.e, 8%. Hence, the proposal of purchasing the machine should be accepted.

2. IRR of the given machine is 9% which means machine is generating income at the arte of 9% which is more than the required rate of return of 8%. Hence, purchasing the machine is beneficial for the company.

ASSUMPTION: It is assumed that the company is a profitable company and the tax shield of Euro 160 in the first year of the machine has been utilised in other profits.