Investment analysis
In order to choose which option is the best, there is a need to calculate at first Net Present Value and pick the one with the biggest value:
Option 1: to add a new window: NPV (1) = 44,0001,15 + 44,0001,15 x 1.15 + 44,0001,15 x 1,15 x 1,15 – 75,000 = 38,260 + 33,270 + 28,930 – 75,000 = 25,460 $.
Option 3: to build a new stand: NPV (3) = 70,0001,15 + 70,0001,15 x 1.15 + 70,0001,15 x 1,15 x 1,15 – 125,000 = 60,869 + 52,930 + 46,026 – 125,000 = 34,825 $.
Option 4: to rent a larger stand: NPV (4) = 12,0001,15 + 12,0001,15 x 1.15 + 12,0001,15 x 1,15 x 1,15 – 1,000 = 10,434 + 9,037 + 7,890 – 1,000 = 26,361 $.
I recommend proposal 3 – to a build a new stand as it has the largest net present value – 34,825.
2) Now let us compute the IRR for each case. IRR is a rate of return that makes the NPV of all cash flows from a certain project equal to 0.
Option 1: to add a new window: IRR (1) = 35%, NPV = 44,0001,35 + 44,0001,35 x 1,35 + 44,0001,35 x 1,35 - 75,000 = 0
Option 2: to update existing equipment: IRR (2) = 15, 5% NPV = 23,0001,155 + 23,0001,155 x 1,155 + 23,0001,155 x 1,155 x 1,155 - 50,000 = 0
Option 3: to build a new stand: IRR (3) = 30%, NPV = 70,0001,3 + 70,0001,3 x 1,3 + 70,0001,3 x 1,3 x 1,3-125,000 = 2 ( 0).
Option 4: to rent a larger stand: IRR (4) = 1100 %, NPV = 12,0001+11 + 0 - 1,000 = 0
I recommend proposal 4 – to rent a larger stand as it has the largest IRR – 1100%.
3) Differences between NPV and IRR:
NPV is expressed in the form of currency return which a firm expects from the investment, IRR -in the form of percentage return.
NPV is absolute measure, whilst IRR is a relative one.
NPV takes into account additional shareholder’s wealth for calculating the profitability of the investment while IRR does not.
NPV method can be used to evaluate investments where there are changes in cash flows, while IRR cannot.
If discount rate changes, NPV produce different results for the same project. However, IRR produces same results even if the discount rate changes in the same project.
NPV method is better understandable by students as it is easy to grasp, when IRR is more used by business managers as it is better to understand the concept of returns stated in percentage (Kaushal, 2015).
Payback period = Initial investmentCash flow per period= 35,0005,000 = 7 years;
NPV = 4,464 + 3,985 + 3,558 +3,177 + 2,837 + 2,533 + 2,261 + 2,019 + 1,803 + 1,609 + 1,437 + 1,283 + 1,145 + 1,023 + 0,913 – 35,000 = 35,000 – 35,000 = 0
IRR, respectively, = 12 %.
The outcome: there is no need for Rainbow Product this machine, as NPV = 0 and IRR equals the rate of return, which is not profitable at at all. They at least should by slightly bigger.
Even if we assume that all cash flows occurred at the end of the year without considering taxes, NPV < 0, which is furthermore not profitable for the investor:
NPV = 0+0+ +0+ 15 x 5,0005,473 – 35,000 = 13,703 – 35,000 = – 21,297 $.
NPV = 4,5001,12 + 4,5001,2544 + = 4,5000,12 = 37500 $, which is > 0, so is efficient and profitable for the company. While comparing with case I, it will never be profitable (NPV=0). The result: Rainbow Products should purchase the machine with the service contract.
PV = 5,0001,12 + 5,2001,12 x 1,12 + 5,4081,12 x 1,12 x 1,12 += 4,464 + 4,145 + 3,850 + 3,574 + 3,319 + 3,081 + 2,862 + 2,658 + 2,468 + 2,291 + 2,127 + 1,975 + 1,834 + 1,703 = 35,887
NPV = PV – Investments = 35,887 – 35,000 = 0,887 ( 0)
Bibliography
Kaushal, N. (2015). NPV vs IRR - Which is Better? - WallStreetMojo. [Online] Free Investment Banking Tutorials |WallStreetMojo. Available at: http://www.wallstreetmojo.com/npv-vs-irr/ [Accessed 15 May 2016].
