Bailey, Inc. is considering buying a new gang punch that would allow them to pro

Question

Bailey, Inc. is considering buying a new gang punch that would allow them to produce circuit boards more efficiently. The punch has a first cost of $100,000 and a useful life of 15 years. At the end of its useful life, the punch has no salvage value. Labor costs would increase $2,000 per year using the gang punch but raw material costs would decrease $12,000 per year. MARR is 5%/yr. a. What is the internal rate of return of this investment? b. What is the decision rule for judging the attractiveness of investments 13. based on internal rate of return? c. Should Bailey buy the gang punch?

Explanation / Answer

Facts of the question:

1. Comapny would save a cost of $12,000 in raw material while will incur additional labor of 2000. In conclusion, it will save a total of $10,000 per year for 15 years.

2. Year 0 outflow would be 100,000 for gang punch Year 1-15 would be inflow of $10,000 each year.

Present value of outflow of 100,000 (Yr 0) = 100,000

Present value of inflow of $10,000 (Yr 1-15) @ 5% per year = 10,000*10.3796= 103,796

Since NPV is positive 3796 (103,796- 100,000), Bailey should buy the punch.

Decision rule for judging the investment at IRR: If Internal rate of return is higher than MARR, investment is worth to make means it has positive NPV. If IRR is less than MARR, it is not an attractive investment

Computation of IRR:

At a MARR of 5%, NPV is positive. IRR is the rate at which NPV becomes zero. If NPV of 3796 is supposed to bring down, we will have to guess IRR as higher than 5%.

Let's calculate at 6%; NPV= 10000*9.7122- 100000= (2878)

Since at 6% , NPV is negative. It means IRR falls between 5% and 6%.

Applying the formuae, IRR= 5% + (6%-5%) / (-3796-2878) * -3796= 5.56%

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