QUESTION B i need the answer Question #2 (12.5 marks)

Stephen Herron, owner of a small manufacturer, Intuitive Technology (IT), has asked you to provide your opinion on the options available to replace an old machine. Two suppliers have provided price and cost estimates. The supplier of the old machine, Canadian Equipment Inc. (CEI), has improved its equipment but continues with the same specialized design. A new supplier, Alto Design Equipment (ADE), has a new innovative design that can process the products produced by IT.

Stephen is excited about the new design. Its products usually have a short life cycle where sales increase for five years and then decline. IT could use the new design proposed by ADE to process its products that will stabilize output over the next five years. ITs cost of capital is 10%. After careful analysis of the two designs, he prepares the following forecast of the expected cash flows.

After-tax cash inflows and outflows for CEI and ADE equipment ($000)

Machine	Initial investment	Incremental after-tax cash flow in period
		1	2	3	4	5
CEI	$150,000	$ 60,000	$ 50,000	$ 50,000	$ 35,000	$ 35,000
ADE	$260,000	50,000	40,000	30,000	25,000	25,000

1. Stephen believes in the Payback Period technique. He believes that any project that does not return its cost within three years should not be undertaken. Which machine should IT buy if the Payback Period technique is used?

Year	CEI	Payback of CEI	ADE	Payback of ADE
0	-150,000	-150,000	-260,000	-260,000
1	60,000	-90,000	50,000	-210,000
2	50,000	-40,000	40,000	-170,000
3	50,000	10,000	30,000	-140,000
4	35,000	-	25,000	-115,000
5	35,000	-	25,000	-90,000

As shown in the above table;

Payback Period for CEI = 2 and 10,000/50,000 years

= 2 and 0.2 years

= 2 years and 2.4 months

Payback Period for ADE = As shown in the above table, with ADE machine Stephen is not going to recover the cost even within 5 years. ADE machine will take more than 5 years to cover the cost where its products have a shorter lifestyle that sales will decrease after 5 years.

Since Stephen believes that any project that does not return its cost within three years should not be undertaken, he should buy the machine from Canadian Equipment Inc. (CEI) because it has 2 years and 2.4 months payback period if he uses the Payback Period Technique.

2. Stephens wife, a business school graduate, likes the NPV method, since she knows that this method explicitly considers the cost of financing associated with the investment, as well as the time at which cash flows occur. Calculate the NPV and Profitability Index (PI) of each project. Which machine should IT buy according to this criterion?

3. Stephens neighbor is a business analyst and he considers Internal Rate of Return to be far superior method to analyze projects. He determines that, for this type of equipment, the rate of return should be at least 17%. Calculate the IRR for CEI and ADE.

Year	CEI	IRR	ADE	IRR
0	-150,000	18.18%	-260,000	-14.20%
1	60,000		50,000
2	50,000		40,000
3	50,000		30,000
4	35,000		25,000
5	35,000		25,000

As Stephans neighbor has determined that the rate of return for this type of equipment should be at least 17%, it can be concluded that the machine CEI, has met this standard in comparison to the machine ADE. As the IRR for CEI is 18.18%, it satisfies the standard and the machine, CEI should be considered for the new machine.

4. Write a memo to Stephen to help him decide which method he should use in making his decision. In your memo, include a table that shows your results for each of the methods, as shown below. Include a short description of your analysis, the results of each method, and your final reasoned recommendation.

Machine	Initial investment
		Payback Period	NPV	IRR	P.I.
CEI	$150,000
ADE	$260,000