Question Three

Alpha Ltd is a small company that has just raised 200,000 of loans and would like to use this to invest in one of two mutually exclusive projects. The first project is an investment in new machinery for existing production. The second investment would be in new machinery that would add a new product, the Beta, to its existing product range. All of the finance raised would be needed to buy the machinery for either project. Both sets of machinery are expected to last for five years and have no scrap value.

The new machinery would result in labour savings of 80,000 for each of the next five years. However, this would result in some of the present labour being surplus to requirements and there would need to be extra redundancy payments given immediately amounting to 30,000 for each of two employees.

The machinery used in the second project to produce the Beta would result in extra sales of Betas as follows over the next five years:

Year 1 5,000 Betas

Year 2 10,000 Betas

Year 3 15,000 Betas

Year 4 20,000 Betas

Year 5 15,000 Betas

It is expected that a Beta would sell for 10. Labour and material costs for each Beta would amount to 5 per Beta.

Required:

1. Calculate the Payback Period for each project (4 marks)

2. Calculate the Net Present Value of each project when discounted at the companys cost of capital of 10%. (8 marks)

3. Calculate the Internal Rate of Return for each project (8 marks)

4. Recommend which project should be undertaken and any other considerations that should be taken into account. (5 marks)

(Total: 25 marks)

Discount factors taken from present value tables are as follows:

Year 10% 20%

1 0.909 0.833

2 0.826 0.694

3 0.751 0.579

4 0.683 0.482

5 0.621 0.402