Question

EX 25-18 Internal rate of return method—two projects Toasted Treats Snack Company is considering two possible investments: a delivery truck or a bagging machine. The delivery truck would cost $44,271 and could be used to deliver an additional 61,000 bags of pretzels per year. Each bag of pretzels can be sold for a contribution margin of $0.40. The delivery truck operating expenses, excluding depreciation, are $0.70 per mile for 21,000 miles per year. The bagging machine would replace an old bagging machine, and its net investment cost would be $49,920. The new machine would require three fewer hours of direct labor per day. Direct labor is $16 per hour. There are 250 operating days in the year. Both the truck and the bagging machine are estimated to have seven-year lives. The minimum rate of return is 13%. However, Toasted Treats has funds to invest in only one of the projects. a. Compute the internal rate of return for each investment. Use the present value of an annuity of $1 table appearing in this chapter (Exhibit 2). b. Provide a memo to management with a recommendation.

Answer 1

Solution

Toasted Treats Snack Company

Basic Calculations –

Investment projects		Delivery Truck	Bagging Machine
Cost		$44,271	$49,920
Additional Contribution	(At $0.40 per bag, 61,000 bags	$24,400
Savings in direct labor hours	(3hrs at $16 per hour for 250 hrs)		$12,000
Operating expenses	(at $0.70 per mile, 21,000 miles	$14,700
Net Additional Earnings per year		$9,700	$12,000
Estimated useful life		7 years	7 years
Annual earnings for the entire useful life		7 x $9,700	4x 12,000
		67,900	$48,000

Computation of internal rate of return:

Internal rate of return (IRR) is the discount rate at which the NPV of the project equals to zero.

NPV (net present value) = present value of cash flows from an investment – initial investment

Use trial and error method to arrive at IRR

Since the given cost of capital of the company is 13%, the IRR should be closer

Calculating NPV for 15% discount rate,

	Delivery Truck	Bagging Machine
initial investment	($44,271)	($49,920)
Annual cash inflows	$9,700	$12,000
Annuity value of $1 for 7 years	4.16	4.16
Annuity of cash inflows	$40,352	$49,920
NPV	($3,919)	0

Since the NPV of Bagging Machine is 0 at 15% discount rate, IRR for Baggage Machine is 15%.

At 15% discount rate, Delivery Truck NPV is lower.

So, the IRR for Delivery Truck would be much lower.

Calculating NPV of Delivery Truck at a discount rate of 12%,

Annuity of $1 at 12% for 7 years

Annuity of cash inflows, $9,700 at 12% discount rate = 9,700 x 4.5638 = $44,269

Present value of initial investment in year 0 = $44,271 x 1 = ($44,271)

NPV for Delivery Truck                     =0

(+/- 1 or 2 is negligible, 44,271 – 44269 =2)

Hence, IRR for Delivery Machine is 12%

	Delivery Truck	Bagging Machine
Present Value Factor	4.5638	4.16
Internal Rate of Return	12%	15%

Since, the company has funds to invest in only one option, the profitable option is investment in Bagging Machine.

Memo:

The IRR of Bagging Machine – 15% is higher than the IRR of Delivery Truck – 12%. Since the company’s minimum rate of return is 13%, the company should choose to invest in Bagging Machine, which has a higher IRR (15%) compared to the minimum rate of return, 13%. The recommendation is to choose to invest in Bagging Machine.