Question

7.43 A company has to decide between two machines that do the same job but have different lives. Net Cash Flow Machine A – $40,000 – $15,000 – $15,000 -$15,000 Machine B -$55,000 $10,000 -$10,000 $10,000 – $10,000 Which machine should the company buy, at an interest rate of 10%, based on the principle of internal rate of return? Assume a financing rate of 8%.

Answer 1

The cash flow schedule is confusing with all carrying negative sign

So i am assuming that the first year cash flow (first row) is an outflow and other cash flows mentioned in following rows are inflows (positive cashflows)

Interest rate/discount rate = 10%

By calculating the PV of cashflows in each of the year (calculations below) using formula PV = FV/(1+10%)^n

			PV Calculation
Machine A	Machine B		Machine A	Machine B
			10%	10%
-40000	-55000		PV =-40000 [-40000/(1+10%)^0]	PV =-55000[-55000/(1+10%)^0]
15000	10000		PV =13636.36 [15000/(1+10%)^1]	PV = 9090.91[10000/(1+10%)^1]
15000	10000		PV =12396.69[15000/(1+10%)^2]	PV = 8264.46[10000/(1+10%)^2]
15000	10000		PV =11269.72[15000/(1+10%)^3]	PV = 7513.15[10000/(1+10%)^3]
	10000			PV = 6830.13[10000/(1+10%)^4]
	NPV		-2697.22	-23301.35
	IRR		6.13%	-11.62%

By NPV analysis, Machine A as lesser NPV compared to Machine B (however, both machines have negative NPV)

IRR calculation; we can calculate IRR only by trial and error method in excel or by using the formula in excel. By trial and error method, IRR of machine A is positve i.e. 6.13%, however for Machine B, IRR is negative i.e. -11.62% This means that sum of all cash flows is negative (even without discounting)

So we will choose machine A as it has a postive IRR%