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
3.1 Accounting Rate of Return (ARR) for Machine A:
ARR = Average Annual Profit / Average Investment
Average Annual Profit = (340,000 + 280,000 + 550,000 + 340,000 + 160,000) / 5 = 334,000
Average Investment = (Initial Cost - Scrap Value) / 2 = (3,000,000 - 200,000) / 2 = 1,400,000
ARR = 334,000 / 1,400,000 = 0.2386 or 23.86%
3.2 Net Present Value (NPV) for Machine A and Machine B:
NPV = ∑(Net Cash Inflows / (1+r)^t) - Initial Investment
For Machine A:
NPV = (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) - 3,000,000
NPV = 1,366,748.26 - 3,000,000 = -1,633,251.74
For Machine B:
NPV = (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) - 3,000,000
NPV = 1,539,363.96 - 3,000,000 = -1,460,636.04
3.3 Internal Rate of Return (IRR) for Machine B using interpolation:
IRR = Lower Discount Rate + NPV at Lower Rate / (NPV at Lower Rate - NPV at Higher Rate) * (Higher Rate - Lower Rate)
At 15%:
NPV = (340,000 / (1+0.15)^1 + 340,000 / (1+0.15)^2 + 340,000 / (1+0.15)^3 + 340,000 / (1+0.15)^4 + 340,000 / (1+0.15)^5) - 3,000,000
NPV = 1,702,472.46 - 3,000,000 = -1,297,527.54
At 16%:
NPV = (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) - 3,000,000
NPV = 1,539,363.96 - 3,000,000 = -1,460,636.04
IRR = 15% + (-1,297,527.54) / ((-1,297,527.54) - (-1,460,636.04)) * (16% - 15%)
IRR = 15% + 0.421 * 1%
IRR = 15.421%
3.4 Payback Period for Machine A:
Payback Period = Initial Investment / Average Annual Cash Inflow
Average Annual Cash Inflow = (340,000 + 280,000 + 550,000 + 340,000 + 160,000) / 5 = 334,000
Payback Period = 3,000,000 / 334,000 = 8.98 years (rounded to 9 years)