ABC Ltd manufactures toys and other short lived fad items. The research and development department has come up with an item that would make a good promotional gift for office equipment dealers. As a result of efforts by the sales personnel, the firm has commitments for this product.

To produce the quantity demanded, ABC Ltd will need to buy additional machinery and rent additional space. The equipment will be purchased for Rs.900, 000. It will require RS. 30,000 in modifications, RS. 60,000 for installation and RS. 90,000 for testing. The equipment will have a salvage value of about Rs.180, 000 at the end of the third year. Equipment is expected to be sold at the end of project at salvage value. Working capital will increase by RS. 100,000 at the start of project and will be recovered by full amount at the end of project. No additional expenses are expected to be incurred.

The estimates of revenues and costs for this product for the three years have been developed as follows:

Particulars

Year 1

Year 2

Year 3

Sales

Rs.10,00,000

Rs.20,00,000

Rs.8,00,000

Less Costs:

Material, Labor and overhead incurred

400,000

750,000

350,000

Overhead allocated

40,000

750,000

35,000

Rent

50,000

50,000

50,000

Depreciation

300,000

300,000

300,000

Total Costs

790,000

1,175,000

735,000

Earnings before taxes

210,000

825,000

65,000

Less taxes

84,000

330,000

26,000

Earnings after taxes

126,000

495,000

35,000

Company sets a required rate of return of 15% that can be treated as discount rate.

Instructions: Calculate

1.Payback method

2.NPV (decide project should accept or not)

3.IRR (compare IRR with discount rate and suggest what you understand)

4.Why should we take decision based on NPV rather than payback method, give argument in support of your answer?

5.Would you prefer to use IRR for decision making or NPV? Give argument in support of your answer