Question

After graduating UK with a major in finance, you have developed a brilliant new widget. You sell your widgets for $6. You need to buy a machine to produce your widgets. You are considering two machines:

Machine A:

• Cost $2,000,000
• Annual fixed cost per machine: $250,000; Variable cost per unit $1.40
• Annual production capacity: 300,00 widgets (i.e., you cannot produce more than 300,000 widgets)
• Market life = 5 years; terminal (market) value =0

Machine B:

• Cost $6,000,000
• Annual fixed cost per machine: $25,000; Variable cost per unit $0.40
• Annual production capacity: 600,00 widgets (i.e., you cannot produce more than 600,000 widgets)
• Market life = 5 years; terminal (market) value = $200,000

Additional Details:

• You have already had an inspector evaluate Machine A for $2,000 and Machine B for $6,000.
• Both machines can be depreciated using straight-line depreciation over a 5-year period. Book value should =0 at the end of 5 years.
• The tax rate is 30%
  • If Net Income is negative, assume a tax of 0 (i.e. the government will not pay you if you lose money, and there are no tax-loss carry forwards)
• The discount rate is 6%
• You expect to be able to sell up to 400,000 widgets
  • Assume you can only buy one machine

1. Compute the NPV and IRR of both projects. [12 points]
   1. Which project should you take according to the NPV rule?
   2. Which project should you take according to the IRR rule?

Answer 1

Machine A

Machine B

i) According to the NPV rule, Machine B is better as it has a higher NPV.

ii) According to the IRR rule, Machine A is better as it has a higher IRR.