Net Present Values and Internal Rates of Return Assignment
Machalo Limited is a fashion company. Michael, one of the ‘bright young things’ who works in the design department, has come up with a new style of a T-shirt – the D’urberville. The product is not expected to have a long sales run but will be popular whilst it lasts.
Two methods of promoting the T-shirt are available:
Method 1: ‘swamping the market’ – this would involve an initial advertising campaign costing K100,000 and would result in net cash inflows after one year of K230,000. However, commission of K132,000 would have to be paid one year after the inflows.
Method 2: waiting for the market to develop gradually. This would involve an initial advertising campaign costing K70,000 and would result in net cash inflows of zero after one year and K38,000 at the end of each of the subsequent three years.
Mrs Kangwa, a director of Machalo Limited, has commented: ‘Method 1 can’t be acceptable since the net receipts of K230,000 are less than the total outflows of K232,000. Method 2 can’t be adopted since the expense of K70,000 in a year with no revenue to show for it will mean that we won’t have enough money to pay the dividend which our shareholders require.’
Machalo Limited’s cost of capital is 15%. The directors do not expect capital to be in short supply during the next four years.
Page 3 of 13
a) Calculate the net present values and estimate the internal rates of return of the two methods of promoting the new product. (12 Marks)
b) Advise the directors of Machalo Limited which method they should adopt, explaining the reasons for your advice and noting any additional information you think would be helpful in making the decision. (7 Marks)
c) Comment on the views expressed by Mrs Kangwa. (6 Marks)