Define the term IRR (i.e. Internal Rate of Return)
Explain the decision criteria in applying the IRR
Discuss facts about the IRR
Mitt Telecoms Inc. (MT Co) is a limited company that specialises in the provision of telephone systems for commercial clients. There are two parts to the business:
a. Installing telephone systems in businesses, either first time installations or replacement installations;
b. Supporting the telephone systems with annually renewable maintenance contracts.
MT Co has been approached by a potential customer, Push Co, who wants to install a telephone system in new offices it is opening. Whilst the job is not a particularly large one, MT Co is hopeful of future business in the form of replacement systems and support contracts for Push Co. MT Co is therefore keen to quote a competitive price for the job. The following information should be considered:
1. One of the company’s salesmen has already been to visit Push Co, to give them a demonstration of the new system, together with a complimentary lunch, the costs of which totalled $400.
2. The installation is expected to take one week to complete and would require three engineers, each of whom is paid a monthly salary of $4,000. The engineers have just had their annually renewable contract renewed with MT Co. One of the three engineers has spare capacity to complete the work, but the other two would have to be moved from contract X in order to complete this one. Contract X generates a contribution of $5 per engineer hour. There are no other engineers available to continue with Contract X if these two engineers are taken off the job.
It would mean that MT Co would miss its contractual completion deadline on Contract X by one week. As a result, MT Co would have to pay a one-off penalty of $500. Since there is no other work scheduled for their engineers in one week’s time, it will not be a problem for them to complete Contract X at this point.
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3. MT Co’s technical advisor would also need to dedicate eight hours of his time to the job. He is working at full capacity, so he would have to work overtime in order to do this. He is paid an hourly rate of $40 and is paid for all overtime at a premium of 50% above his usual hourly rate.
4. Two visits would need to be made by the site inspector to approve the completed work. He is an independent contractor who is not employed by MT Co, and charges Push Co directly for the work. His cost is $200 for each visit made.
5. MT Co’s system trainer would need to spend one day at Push Co delivering training. He is paid a monthly salary of $1,500 but also receives commission of $125 for each day spent delivering training at a client’s site.
6. 120 telephone handsets would need to be supplied to Push Co. The current cost of these is $18·20 each, although MT Co already has 80 handsets in inventory. These were bought at a price of $16·80 each. The handsets are the most popular model on the market and frequently requested by MT Co’s customers.
7. Push Co would also need a computerised control system called ‘Swipe 2’. The current market price of Swipe 2 is $10,800, although MT Co has an older version of the system, ‘Swipe 1’, in inventory, which could be modified at a cost of $4,600. MT Co paid $5,400 for Swipe 1 when it ordered it in error two months ago and has no other use for it. The current market price of Swipe 1 is $5,450, although if MT Co tried to sell the one they have, it would be deemed to be ‘used’ and therefore only worth $3,000.
8. 1,000 metres of cable would be required to wire up the system. The cable is used frequently by MT Co and it has 200 metres in inventory, which cost $1·20 per metre. The current market price for the cable is $1·30 per metre.
9. You should assume that there are four weeks in each month and that the standard working week is 40 hours long.
Prepare a cost statement, using relevant costing principles, showing the minimum cost that MT Co should charge for the contract. Make DETAILED notes showing how each cost has been arrived at and EXPLAINING why each of the costs above has been included or excluded from your cost statement.
You will take on the role of a junior consultant working within a team at North Derby Consulting Company. You are expected to produce a written report suitable for presentation to the senior management team of the consulting company, which they will use to present to the senior management of a client company.
To help you with your project your seniors have specified the following requirements:
1. You are required to write a report on “What managers should know about IRR and why”.
2. The report should, amongst others, critically discuss the decision criteria in applying the IRR for investment appraisal purposes, IRR as a sensitivity analysis tool, especially for brainstorming at senior management meetings, and the practical problems with the application of IRR for investment appraisal purposes. You must also compare IRR with other investment appraisal methods in terms of decision criterion, complexity of application, time value of money, and risks appraisal.
3. The work should be in Report form and should be approximately 1,500 words excluding appendices and references.
4. Marks will be specifically allocated to logical presentation.
5. The usual University penalties for plagiarism apply – see the regulation
A major stipulation is that the report should not be more than 1,500 words excluding appendices and references otherwise the managers will stop reading your report and will probably request that you are not re-engaged by the company in the future!
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