LF Ltd wishes to manufacture a new product. The company is evaluating two mutually exclusive machines, the

Question:

LF Ltd wishes to manufacture a new product. The company is evaluating two mutually exclusive machines, the Reclo and the Bunger. Each machine is expected to have a working life of four years, and is capable of a maximum annual output of 150 000 units.
Cost estimates associated with the two machines include:

The Reclo requires 120 square meters of operating space. LF Ltd currently pays £35 per square meter to rent a factory which has adequate spare space for the new product. There is no alternative use for this spare space. £5000 has been spent on feasibility
survey of the Reclo.
The marketing department will charge a fee of £75 000 per year for promoting the product, which will be incorporated into existing plans for catalogues and advertising. Two new salesmen will be employed by the marketing department solely for the new product, at a cost of £22 500 per year each. There are no other incremental marketing costs.
The selling price in year one is expected to be £3.50 per unit, with annual production and sales estimated at 130 000 units throughout the four year period. Prices and costs after the first year are expected to rise by 5 per cent per year. Working capital will be increased by this amount from year one onwards.
Taxation is payable at 25 per cent per year one year in arrears and a writing-down allowance of 25 per cent per year is available on a reducing balance basis.
The company's accountant has already estimated the taxable operating cash flows (sales less relevant labour costs, materials costs etc., but before taking into account any writing-down allowances) of the second machine, the Bunger. These are:

Required:
(a) Calculate the expected internal rate of return (IRR) of each of the machines. State clearly any assumptions that you make.
(b) Evaluate, using the incremental yield method, which, if either, of the two machines should be selected.

Internal Rate of Return
Internal Rate of Return of IRR is a capital budgeting tool that is used to assess the viability of an investment opportunity. IRR is the true rate of return that a project is capable of generating. It is a metric that tells you about the investment...