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Chapter 26: Q25RQ (page 1464)
What is the internal rate of return?
The internal rate of return (IRR) is a statistical tool used for various financial research. It is used to define the profitability of potential investments. A discount rate brings all future cash flows net present values (NPV) to zero.
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Question: What is an annuity? How does it differ from a lump sum payment?
Using payback, ARR, and NPV with unequal cash flows
Hughes Manufacturing, Inc. has a manufacturing machine that needs attention. The company is considering two options. Option 1 is to refurbish the current machine at a cost of \(2,600,000. If refurbished, Hughes expects the machine to last another eight years and then have no residual value. Option 2 is to replace the machine at a cost of \)3,800,000. A new machine would last 10 years and have no residual value. Hughes expects the following net cash inflows from the two options:
Year | Refurbish current machine | Purchase new machine |
1 | \(1,760,000 | \)2,970,000 |
2 | 440,000 | 490,000 |
3 | 360,000 | 410,000 |
4 | 280,000 | 330,000 |
5 | 200,000 | 250,000 |
6 | 200,000 | 250,000 |
7 | 200,000 | 250,000 |
8 | 200,000 | 250,000 |
9 | 250,000 | |
10 | 250,000 | |
Total | \(3,640,000 | \)5,700,000 |
Hughes uses straight-line depreciation and requires an annual return of 10%.
Requirements
1. Compute the payback, the ARR, the NPV, and the profitability index of these two options.
2. Which option should Hughes choose? Why?
What is the profitability index? When is it used?
Mountain Manufacturing is considering the following capital investment proposals. Mountain’s requirement criteria include a maximum payback period of five years and a required rate of return of 12.5%. Determine if each investment is acceptable or should be rejected (ignore qualitative factors). Rank the acceptable investments in order from most desirable to least desirable
Project | A | B | C | D | E |
Payback | 3.15 years | 4.20 years | 2.00 years | 3.25 years | 5.00 years |
NPV | \(10,250 | \)42,226 | (\(10,874) | \)36,251 | $0 |
IRR | 13.0% | 14.2% | 8.5% | 14.0% | 12.5% |
Profitability index | 1.54 | 1.92 | 0.75 | 2.86 | 1.00 |
Refer to the Hunter Valley Snow Park Lodge expansion project in Short Exercise S26-4 and your calculations in Short Exercises S26-5 and S26-6. Assume the expansion has zero residual value.
Requirements
1. Will the payback change? Explain your answer. Recalculate the payback if it changes. Round to one decimal place.
2. Will the project’s ARR change? Explain your answer. Recalculate ARR if it changes. Round to two decimal places.
3. Assume Hunter Valley screens its potential capital investments using the following decision criteria:
Maximum payback period | 5.0 years |
Maximum accounting rate of return | 18.00% |
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