A small manufacturing company is considering the addition of one or more new pro

Question

A small manufacturing company is considering the addition of one or more new product lines. If the total amount of investment capital available for new ventures is $800,000 which one should the company undertake on the basis of rate of return? Assume the company uses a 5-year project recovery period and a MARR of 20% per year. All cash flow are in $1000 units. The rate of return must determine using trial and error method Product Lines The rate of return must determine using trial and error method

Explanation / Answer

Answer:

MARR = 20%

Year (n) = 5 years

Note: all cash inflows and outflows are in $1000 units.

For Product Line T3

Let, rate of return = R1

Thus,

Initial investment = Present value of net cash inflows

500 = (470-400)*(1-1/(1+R1)^n)/R1

500 = 70*(1-1/(1+R1)^5)/R1

At R3 = - 11%

PV of net cash inflows = $503.24

Thus, by trial and error, rate of return will be -11% approx.

For Product Line S2

Let, rate of return = R2

Thus,

Initial investment = Present value of net cash inflows

400 = (450-300)*(1-1/(1+R2)^n)/R2

400 = 150*(1-1/(1+R2)^5)/R2

At R2 = 26%

PV of net cash inflows = $396.26

At R2 = 25%

PV of net cash inflows = $403.39

Thus, as per the method of interpolation

R2 = 25% + ((PV at 25% - initial investment )/( PV at 25% - PV at 26%))*(26% - 25%)

R2 = 25% + ((403.39-400)/(403.39-396.26))*(26% - 25%)

R2 = 25.47%

For Product Line U4

Let, rate of return = R3

Thus,

Initial investment = Present value of net cash inflows

700 = (470-400)*(1-1/(1+R3)^n)/R3

700 = 70*(1-1/(1+R3)^5)/R3

At R3 = - 19%

PV of net cash inflows = $688.20

At R3 = -20%

PV of net cash inflows = $718.11

R3 = -20% + ((718.11-700)/(718.11-688.20))*(-19% +20%)

R3 = - 19.39%

For Product Line R1

Let, rate of return = R4

Thus,

Initial investment = Present value of net cash inflows

200 = (320-215)*(1-1/(1+R4)^n)/R4

200 = 105*(1-1/(1+R4)^5)/R4

At R4 = 44%

PV of net cash inflows = $200.09 and it is equal to initial investment.

Thus, rate of return R4 is 44% approx.

R1 line is offering the return of 44% and S2 line is offering the return of 25.47%. these two lines’ return is higher than the MARR of 20%. Thus, R1 and S2 product line should be shortlisted for investment. Besides, other two lines T3 and U4 are offering negative returns. Thus, T3 and U4 are not good for investment.

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