February 25, 2013
1a. The results of NPV, payback and IRR calculations are the following. For payback method, Rainbow Product will pay back the original investment costs after 7 years. Net Present Value is -$946 and IRR is 11.49%. Rainbow Products should not purchase the machine according to the results of NPV and IRR calculation. The net present value of purchasing this new equipment is negative, and the internal rate of return is less than the cost of capital; thus both calculations confirm that the investment will not provide additional value to the company. Of course the payback method shows that the instrument will have paid back the cost in 7 years but does not take into consideration discounting present values. 1b. If Rainbow accepts the “Good As New” service plan, net present value will be a positive $2,500 and IRR will be 12.86%, greater than the cost of capital. The investment would also pay back the cost in 8 years. Rainbow should purchase the machine under this service plan as it results in a positive net value and the internal rate of return is greater than the cost of capital. 1c. If Rainbow chooses the reinvestment option, net present value is $15,000 and IRR is 15.43%. Therefore, the best investment decision is to accept option C, where engineers reinvest 20% of the savings that help cash flows grow 4% in perpetuity. Figure 1 (applicable to question 1a~1c)
2. Using the IRR rule, I recommend renting a larger stand as it yields the greatest rate of return. Using the NPV rule, I recommend building a larger stand.
IRR rule can be misleading in this case as this problem is comparing 4 mutually exclusive projects and given the stats, IRR for one out of four of these projects yields a much higher value, but none of these IRR values take discounting rate into consideration. Therefore, NPV is a better method. Figure 2
3. The NPV of this project is $100,000. 1,100 shares of common...