9: Capital Budgeting Process and Decision Criteria9 -7d CONCLUSION
Notice that the cash flows associated with each machine differ in three important ways. First, Ana-Lab
must invest a lot more money to purchase the Type B machine. Second, the Type A machine produces
most of its cash flow in the early years, while the Type B machine produces higher cash flows later in its
life. Third, the Type B machine has net cash outflows up front and in year 6, but the Type A machine
only has an outflow in the initial year.
With respect to the differences in the up-front investments required to purchase each machine, recall
that the NPV and IRR rankings may conflict, because it is sometimes better to accept a lower return on a
larger investment compared to a higher return on a smaller investment. The IRR of the Type A machine
is 18%, but Ana-Lab earns that return on an investment of just $1 million. It is possible that the company
could make more money if it earned a lower rate of return on a much larger investment. That is precisely
what the NPV analysis is telling you, at least when the discount rate is 10%. If 10% is the proper hurdle
rate to apply to this investment decision, then buying the Type B machine creates $388,084 in additional
wealth for the company, even though the rate of return is higher on the other machine.
But if Type B is the right choice at 10%, why is it not correct based on a 13% discount rate? Because the
Type B machine produces so much of its cash flows in years four and five, its NPV is very sensitive to the
discount rate. Figure 9.9 demonstrates this. At relatively low discount rates, the Type B chromatograph
produces a higher NPV compared to the Type A machine, but for higher rates, the NPV of the Type A
machine is higher. The two curves in Figure 9.9 intersect at a discount rate of roughly 12.64%, meaning
that the NPVs of the two machines are equal at that point. Therefore, your advice to Mr Whitehead should
be to purchase the Type B machine if the appropriate hurdle rate is 12.64% or lower, and purchase the Type
FIGURE 9.9 NET PRESENT VALUES OF TWO GAS CHROMATOGRAPHS0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 20%
–$1,000,000
–$500,000
$0
$500,000
$1,000,000
$1,500,000
$2,000,000
When the discount rate
is about 12.64%, the two
machines have identical NPVs.Type A chromatograph
Type B chromatograph