Question 11.1

(a) Although many different methods are used by firms to evaluate capital investment proposals, theoretical arguments suggest that NPV is the best method of appraisal. Explain why this is so.

(b) Research evidence suggests that payback period is a method of evaluation commonly used by firms in evaluating capital investment proposals. Explain why firms might wish to use this method of evaluation.

(c) Marple Manufacturing Ltd is proposing to purchase a new machine to enhance its manufacturing capacity through the making of a new product.

The machine would have a 4-year life with no residual value; it would cost £100 000 and would require also an additional investment in working capital of £60 000. Estimated benefits during its life are as follows:

Year 1 Year 2 Year 3 Year 4 Additional sales (units) 1600 2000 2400 2400 Selling price per unit (£) 55 65 65 65 Variable cost per unit (£) 30 30 25 25 The company has already spent £75 000 on research and development to ensure that the new product will be successful.

If the new machine is purchased, an existing product, giving an annual contribution of £16 000, will have to be withdrawn.

The company uses a weighted average cost of capital of 15 per cent.

You are asked to calculate the NPV of the proposed investment and its IRR.