QUESTION 3 (25 Marks)
INFORMATION
Avery Manufacturers intends purchasing a new machine and has a choice between two
machines viz. Machine A or Machine B. The cost of each machine is R3 000 000, with each
having an expected useful life of five years. Machine A is expected to have a scrap value of
R200 000. No scrap value is expected for Machine B. Avery Manufacturers uses the
straight-line method of deprecation. The cost of capital is estimated at 16%.
Machine A is expected to generate the following net profits over its useful life: Year 1 R340
000
Year 2 R280 000
Year 3 R550 000
Year 4 R340 000
Year 5 R160 000
Machine B is expected to generate a net profit of R340 000 per year over the five-year
period. Ignore taxes.
REQUIRED
Answer the questions based on the information supplied.
Use the information provided below to calculate the following. Where applicable, use the four�decimal present value tables provided in APPENDICES 1 and 2
3.1 Accounting Rate of Return (on initial investment) of Machine A (expressed to two
decimal places) (5)
3.2 Net Present Value of each machine (8)
3. 3 Internal Rate of Return of Machine B (expressed to two decimal places) using
interpolation. (7)
3.4 Payback period for of Machine A (5)
Question 4 (25 marks)
3.1 Accounting Rate of Return (ARR) for Machine A:
Initial Investment = R3,000,000
Net Profit each year = R340,000 (Year 1), R280,000 (Year 2), R550,000 (Year 3), R340,000 (Year 4), R160,000 (Year 5)
Average Annual Profit = (340,000 + 280,000 + 550,000 + 340,000 + 160,000) / 5 = R334,000
ARR = (Average Annual Profit / Initial Investment) * 100
ARR = (334,000 / 3,000,000) * 100
ARR = 11.13%
Therefore, the Accounting Rate of Return for Machine A is 11.13%.
3.2 Net Present Value (NPV) of each machine:
For Machine A:
NPV_A = -3,000,000 + (340,000 / (1 + 0.16)^1) + (280,000 / (1 + 0.16)^2) + (550,000 / (1 + 0.16)^3) + (340,000 / (1 + 0.16)^4) + (160,000 / (1 + 0.16)^5) + (200,000 / (1 + 0.16)^5)
NPV_A = -3,000,000 + 297,413.79 + 219,479.94 + 364,506.17 + 195,852.93 + 81,395.35 + 104,166.67
NPV_A = R(3,012,000.85)
For Machine B:
NPV_B = -3,000,000 + (340,000 / (1 + 0.16)^1) + (340,000 / (1 + 0.16)^2) + (340,000 / (1 + 0.16)^3) + (340,000 / (1 + 0.16)^4) + (340,000 / (1 + 0.16)^5)
NPV_B = -3,000,000 + 293,103.45 + 253,237.59 + 218,365.51 + 188,712.68 + 163,281.70
NPV_B = R(2,116,928.93)
Therefore, the Net Present Value for Machine A is R3,012,000.85 and for Machine B is R2,116,928.93.
3.3 Internal Rate of Return (IRR) for Machine B:
Using interpolation method:
IRR = Lower Rate + [(NPV at Lower Rate) / ((NPV at Lower Rate) - (NPV at Higher Rate))] * (Higher Rate - Lower Rate)
IRR = 16% + [(2,116,928.93) / (2,116,928.93 - 3,012,000.85)] * (20% - 16%)
IRR = 16% + (1,094,072.31 / -895,071.92) * 4%
IRR = 16% + (-1.22) * 4%
IRR = 11.12%
Therefore, the Internal Rate of Return for Machine B is 11.12%.
3.4 Payback period for Machine A:
Payback Period = Number of Years before Cumulative Cash Inflows = Initial Investment
Payback Period = (R3,000,000 - R200,000) / (R340,000 + R280,000 + R550,000 + R340,000 + R160,000)
Payback Period = R2,800,000 / R1,670,000
Payback Period = 1.68 years
Therefore, the Payback Period for Machine A is 1.68 years.