PART 3: CAPITAL BUDGETING
is so different, you worry that a simple payback analysis might lead to a decision that is not best for the
company in the long run.9 -7b INTERNAL RATE OF RETURN
Next, you calculate the rate of return earned by each machine by solving for the IRR as follows:
Type A:r rrrrr
$1,000, 000
$450, 000
1$350, 000
1$250, 000
1$200, 000
1$150, 000
1$125,000
1
2 3456 0
() () () () () ()− +
++
++
++
++
++
+=
rI==RR 0.18=18%
Type B:r rrrrr
$3,200, 000
$500, 000
1$550, 000
1$1,000, 000
1$1,500, 000
1$2,000, 000
1$600, 000
1
23456 0
() () () () () ()− +
++
++
++
++
+−
+=
rI==RR 0.139=13.9%
The Type A machine seems to be the best choice, because it offers an 18% return compared to
13.9% for the Type B machine. You feel somewhat relieved that the IRR analysis favours the Type A
machine, consistent with the conclusion from your payback period analysis. You also feel reassured that
both machines earn a return well in excess of the 10% return that Mr Whitehead said he could earn by
replacing existing equipment. However, you wonder if an investment in gas chromatographs should earn
more than 10%. Perhaps the demand for the tests that the chromatograph can perform is very sensitive to
economic conditions, and if so, the investment may have higher systematic risk than Ana-Lab’s existing
business.9 -7c ADDITIONAL ANALYSIS
Before reporting back to Mr Whitehead, you decide to calculate the NPV for each machine using the
10% hurdle rate that he suggested, as well as a higher rate, 13%, to adjust for the higher risk of these
new machines. Given that IRRs of both machines exceed even the higher of these two hurdle rates, you
expect to find that both machines create value – have a positive NPV – for Ana-Lab. Your calculations
are summarised below:Type A chromatograph Type B chromatograph
NPV at 10% $ 186,476 $388,084
NPV at 13% $1,097,012 $ 83,566What previously seemed to be an easy decision to invest in the Type A machine now appears to be
less clear cut. When you discount the cash flows at the 10% rate suggested by Mr Whitehead, the NPV
of the Type B machine is more than twice as large as the alternative. But at a 13% discount rate, the Type
A machine looks like the better choice. You wonder, what accounts for the conflicting rankings?