Question 9.1: The ABC Company is currently earning an average before-tax r......
The ABC Company is currently earning an average before-tax return of 25% on its total investment. The board of directors of ABC is considering three proposals as given in Table 9-1.
Proposal A is for a new machine that will replace one of their older, worn-out pieces of equipment; this machine is vital to ABC’s production. Proposal B is for a plant expansion. Proposal C is for an addition to ABC’s product line. There is a high probability that this product could fail in the marketplace, resulting in the loss of most of the $50 000 initial investment. The board feel that they would need at least a 40% rate of return on this project to compensate for its additional riskiness. Which of these three proposals are acceptable?
| Table 9-1 | |||
| End of year | Cash Flows | ||
| Proposal A | Proposal B | Proposal C | |
| 0 | -$40 000 | -$60 000 | -$50 000 |
| 1 | 18 000 | 25 000 | 27 000 |
| 2 | 18 000 | 25 000 | 27 000 |
| 3 | 18 000 | 25 000 | 27 000 |
| 4 | 18 000 | 25 000 | 27 000 |
Compute net present values, using the attainable MARR of 25% for proposals A and B, and the target MARR of 40% for proposal C:
NPV_A = -$40 000 + $18 000(P/A, 25%, 4) = +$2508.97
NPV_B = -$60 000 + $25 000(P/A, 25%, 4) = -$959.76
NPV_C = -$50 000 + $27 000(P/A, 40%, 4) = -$71.19
Only proposal A is acceptable (NPV_A > 0).
The ROR method leads to the same conclusion: linear interpolation in Appendix A gives
i_A^* ≈ 28.75% i_B^* ≈ 24.07% i_C^* ≈ 39.99%
and only i_A^* exceeds the associated MARR.
Because NPV_B and NPV_C, though negative, are small in magnitude (causing i_B^* and i_C^* to be just under their associated MARRs), the ultimate decisions concerning proposals B and C may have to be made on the basis of other considerations, such as ABC’s long-term product strategies and the company’s ability to raise capital. If capital is scarce, proposal A must be given the highest priority, since ABC’s continued profits appear to depend on that piece of machinery.