The Board of Peartek Ltd is considering the company’s capital investment options for the coming year, and also evaluating the following potential investments:
Investment A
This investment is similar to its current investments and requires an investment of GH¢60,000 now, GH¢40,000 for new capital equipment and GH¢20,000 for increases in working capital. This will be financed from Shareholders Funds. Sales next year would be 10,000 units, variable costs would be GH¢6 and the product would be sold for GH¢10. But due to entry of new competitors and technological improvements, the sales price would decline by 20% per annum thereafter, sales volume would fall by 10% and variable costs would fall by 20% per annum. Overheads attributed to the project would be GH¢15,000 per annum.
In year three the project would be wound up, working capital investment would be recovered and capital equipment sold off for 25% of its purchase costs the following year. Fixed costs include an annual charge of GH¢4,000 for depreciation.
Investment B
This is a long–term project in a totally new area, involving an immediate outlay of GH¢90,000, which they intend to borrow from their lenders at 6%. They expect net profits of GH¢12,000 next year, rising thereafter by 3% per annum in perpetuity.
Investment C
This is another long-term investment in a totally new area, involving an immediate outlay of GH¢25,000 which they intend financing by retained profits.
Expected annual net cash profits are as follows:
Years 1 to 4 : GH¢3,000
Years 5 to 7 : GH¢5,000
Year 8 onwards forever : GH¢7,000
The company discounts all projects lasting ten years duration or less at a cost of capital of 10% and all other projects at a cost of 13%. You may ignore taxation.
Required:
Minority of board members feel that the Internal Rate of Return (IRR) should also be used as either an alternative or a complementary method of investment appraisal. Calculate the IRR of investments A and B (you may use 25% as the upper limit if you wish) and comment accordingly. (5 marks)
View Solution
From the calculations below, the IRR of Investment A is approximately 23% while the IRR of Investment B is approximately 18.5%. Thus both meet the required return of projects as given by the board of Peartek Ltd. i.e. 10% for all projects lasting ten years duration or less and 13% for all other projects.
INVESTMENT A
NPV= -6,083
IRR = A +{(a/ (a-b) ) * B – A)}
i.e. at r = 10%, NPV = ¢10,226
i.e. at r = 25%. NPV = ¢-2,426.72
IRR = 10% +{(10,226 / ( 10,226 – -6,083)* (25% – 10%)}
. = 10% +{(10,226 / 16,309) * (15%)}
. = 10% +{(0.627) *(15%)}
. = 10% +{0.094}
. = 10% + 9.4%
. = 19.4% approximately
INVESTMENT B
r = 13%
g = 3%
Costs = 90,000
Yr1 = 12,000
NPV = PV Benefits – PV of Costs
PV Benefits = CFI / (r – g)
. = 12,000 /(0.13 – 0.03)
. = GH¢120,000
NPV = ¢120,000 – ¢90,000 = ¢30,000
r = 25%
g = 3%
Costs = 90,000
Yr1 = 12,000
NPV = PV Benefits – PV of Costs
PV Benefits = CFI / (r – g)
. = 12,000 /(0.25 – 0.03)
. = GH¢ 54,545.45
NPV = ¢54,545.45 – ¢90,000 = – ¢35,454.55
i.e. at r = 13%, NPV = GH¢30,000
i.e. at r = 25%, NPV = ¢-35,454.55
IRR = 13% + {(30,000 / (30,000 – – 35,454.55) * (25% – 13%)}
. = 13% + {(30,000 / (65,454.55) * (12%)
. = 13% + {(0.458) * (12%)
. = 13% + {5.50%}
. = 18.50% approximately