Question

FastBits Electronic Company Sdn. Bhd. is evaluating new precision inspection devices to help verify package quality. The manager has obtained the following bids from four companies. All devices have a life of five years and a minimun attractive rate of return of 4%. The alternatives are mutually exclusive. Description Company A Company B Company C Company D Initial Cost (RM) 450000 Annual Costs (RM) 900 Net Cash Flows (RM) 112500 33320 IRR Determine the annual benefits of the devices from all four companies. Company A CompanyIB Company C: Company I Device from which company has the highest annual benefit? FastBits should reject the bid from which company based on the given individual IRR? Using incremental internal rate o return analysis rom which company, if any, should the manager purchase the new precision inspection device? Use trial and error method with 4% and 10% interest rates. Understood? (YN) Step 1- Eliminate Company Step 2 - Rank Company from no 1-2-3 Step 4 Incremental IRR first comparison Step 5- Remove Company from selection Repeat Step 4 Incremental IRR 2nd comparison Step 5 - Choose Company Demonstrate that the same company selection would be made with proper application of the Present Worth (PW) method. PW Company A PW Company B PW Company C PW Company D Thus, choose Company 19000 560000 200000 12000 23000 140000 7.9% 9000 46200 7.9% 12.4% Format: 523300 Format: 84950 Format: 278000 Format: 59400 Format: A Format: A Format:A Format: A Format :x-x-x Format: 3.3 Format: A Format: 9.6 Format: A Form: 70768 Format: 73692 Format: 73335 Format: 4598 Format: A

Answer 1

Please recall that Net Cash flow = Annual benefits - Annual Cost

Hence, Annual benefit = Net cash flow + Annual cost

The two terms on the right hand side of the above equation have been provided in the question. Hence we can calculate the left hand side of the equation by adding net cash flow to the annual cost. Please see the table below:

Description		Company A	Company B	Company C	Company D
Initial Cost	P	450,000	119,000	560,000	200,000
Annual Cost	Q	900	12,000	23,000	9,000
Net cash flow	R	112,500	33,320	140,000	46,200
Annual benefit	S=R+Q	113,400	45,320	163,000	55,200

So, please fill your answers as below

Annual benefit of

Company A: 113400

Company B: 45320

Company C: 163000

Company D: 55200

Device from which company has the highest annual benefit?: C

-----------------------------

If a bid has to be rejected on the basis of IRR, reject the bid with least IRR. Company's D bid has least IRR of 5%.

FastBits should reject bid from which company based on the given individual IRR?: D

------------------------------

Understood (Y/N): Y

Step -1: Eliminate Company: D

We eliminate D upfront because its bid has the least IRR

Step -2:Rank Company 1-2-3: C-A-B

I have ranked on the basis of NPV at discount rate of 4%. Please see table below:

Year	Linkage	-	1	2	3	4	5	NPV at 4%
Cash flows of
Company A	A	(450,000)	112,500	112,500	112,500	112,500	112,500	50,830
Company B	B	(119,000)	33,320	33,320	33,320	33,320	33,320	29,335
Company C	C	(560,000)	140,000	140,000	140,000	140,000	140,000	63,255

NPV has been calculated using NPV function in excel. For example, NPV of company A has been calculated as = -450,000 + NPV(4%,112500, 112500,112500, 112500,112500) = 50,830

Step-3

There is no step 3 in the question

Step-4

Let's have A - B as the first comparison. Please see the table below:

Year	Linkage	-	1	2	3	4	5	NPV@4%	NPV@10%
Cash flows of
Company A	A	(450,000)	112,500	112,500	112,500	112,500	112,500
Company B	B	(119,000)	33,320	33,320	33,320	33,320	33,320
Company C	C	(560,000)	140,000	140,000	140,000	140,000	140,000
Company A - Company B	A - B	(331,000)	79,180	79,180	79,180	79,180	79,180	21,495	(30,846)
Company C - Company A	C - A	(110,000)	27,500	27,500	27,500	27,500	27,500	12,425	(5,753)

Please see the highlighted row above. Incremental cash flows for A - B have been calculated and then NPV of this series has been calculated at discount rate of 4% and 10%.

IRR_A-B = Point interpolated between 4% and 10% = 4% + (10% - 4%) x [21,495 / (21,495 + 30,846)] = 6.5% which is greater than MARR of 4%. Hence select A over B.

Step -4 Incremental IRR first comparison: 6.5

Step-5 Remove company from selection: B

Repeat step 4 for second comparison

Consider C - A. Please see the table above once more, the last row. Incremental cash flows for C - A are given. NPV at 4% and 10% have been calculated, please see the last two columns.

IRR_C-A = Point interpolated between 4% and 10% = 4% + (10% - 4%) x [12,425 / (12,425 + 5,753)] = 8.1% which is greater than MARR of 4%. Hence select C over A.

Repeat Step -4 Incremental IRR second comparison: 8.1

Repeat Step-5 Choose Company: C

Present worth method:

Present worth is NPV at MARR

Hence, PW of Company A's offer @ 4% = -450,000 + NPV(4%,112500, 112500,112500, 112500,112500) = 50,830

PW Company A: 50830

PW of Company B: 29335

PW of Company C: 63255

Thus Choose Company: C