Question 5.S2.RQ.17: ABC Ltd is planning to purchase a machine to meet the increa......
ABC Ltd is planning to purchase a machine to meet the increased demand for its product in the market. The machine costs Rs 50,000 and has no salvage value. The expected life of the machine is 5 years, and the company employs the straight line method of depreciation. The estimated earnings after taxes are Rs 5,000 each year for 5 years.
The after tax required rate of return of the company is 12 per cent.
Determine the IRR. Also, find the pay back period and obtain the IRR from it. How do you compare the IRR with the one directly estimated? What are the reasons for the differences between the two IRRs so estimated?
Earnings after taxes (EAT) Rs 5,000
Add depreciation (D) 10,000
CFAT 15,000
PB period = 3.333 (Rs 50,000 ÷ Rs 15,000). The PV factors closest to 3.333 as per Table A-4 are 3.373 (0.15) and 3.274 (0.16) against five years.
IRR = 0.15 + (0.040/0.099) = 15.4 per cent.
Determination of IRR with the help of PB period:
IRR = 1.000/3.333 = 0.30 = 30 per cent.
The reciprocal of the PB period is a good approximation of IRR if (a) the life of the project is large or at least twice the PB period, and (b) the project generates equal annual cash inflows. In this case, the former condition is not satisfied. Therefore, the value of the IRR determined with the help of PB period is nowhere near the actual value of IRR, 15.4 per cent.