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Determine if CU box, Inc. needs new machine. 2. What method - NPV or others. At present almost every organization tries to use any opportunity (external or internal) with the purpose to attract, reward and retain its shareholders and potential investors. A competitive environment makes companies estimate all possible ways to reach better results and make greater profits. The simplest way is to add up the costs and then to compare the result with expected revenue increases and cost savings.
It can give you a general picture if the total costs are less than the total benefits. But this way is too simple and cannot be used while speaking about big companies capital budgeting; because it does not include all possible costs at the beginning and revenues or cost savings that will occur later. As it was pointed, capital budgeting that includes a firm's long term investments such as new machinery, replacement machinery, new plants, and new products should be based on other more complicated methods. There are several discounted cash flow techniques generally used for capital budgeting such as net present value, internal rate of return, Modified Internal Rate of Return, payback period analysis and equivalent annuity method etc. These methods have their advantages as well as drawbacks. Thats why usually it is better to use more then one for any project.
Even if a project does not pass tests under some or all of these methods it can be used because of its value as a part of a long-range business plan. The simplest way is the payback method. It helps to determine the period when the money spent on the project will return. Two components should be known to determine payback period: cost of project and annual cash inflow. It is known that CU Boxes Inc. expects to buy new machine for $ 1, 000, 000.
The old machine can be sold for $ 30, 000 right now; so the cost of project will be $ 970000. Most of all, operating costs will be reduced by $ 300, 000 per year. So, payback period will be about 3 years. But choosing the method it should be pointed its drawbacks. First of all, it does not take into account any benefits after the payback period. Projects with shorter payback periods will be classified as more profitable than those with longer paybacks.
Partially, it is true, because for shorter payback period the risk that market conditions, interest rates, the economy, or other factors affecting the project will change is less. But according to this statement, project that will return more money for longer period are considered to be worse than ones that return zero with shorter period. Most of all, the method ignores the time value of money. Thats why other methods such as the net present value of the project and the internal rate of return are also used. The internal rate of return (IRR) is often used in capital budgeting.
It's the interest rate that makes net present value (NPV) of all cash flow equal zero. It is always used if a company will earn expanding or investing in itself, rather than investing the money elsewhere. However, there are some projects for which IRR is not effective. The internal rate of return method uses one single discount rate to evaluate every investment. It is the main advantage as well as drawback of the method. From of side, it simplifies matters using one discount rate.
But from the other side, discount rates usually change substantially over time. So, the method is not good for longer-term projects with discount rates that are expected to vary. IRR calculation is ineffective for projects with a mixture of multiple positive and negative cash flows. If market conditions change over the years, such projects can have two or more Irr's.
The other weakness of the internal rate of return method is that it's not as easy to understand as some measures and not as easy to compute. In the case with CU Boxes Inc. an initial investment is $ 1 million. The investment returns $ 300, 000 per year in each of the five years after the initial investment. The company evaluating this investment uses cash flow discounted at 10 %. If the investment's NPV is zero the IRR is a fraction of a percentage point above 15 %; at that discount percentage.
But it is known that if the IRR is above the discount rate, the project is feasible; if it is below, the project is considered infeasible. But the IRR doesn't measure the absolute size of the investment or its return. It can also produce misleading results because it assumes that the cash returned from an investment is reinvested at the same percentage rate, which may not be realistic. However, the method is commonly used in capital budgeting; first of all, because of its simplicity. The IRR method makes projects simple to understand and show the result in numbers that can be use to determine whether or not a project is economically viable. But as it was said, simple IRR isn't good for much more than presentation value.
A standard method in finance of capital budgeting is Net present value (NPV). The method is used for planning of long-term investments. A potential investment project will be beneficial if the present value of all cash inflows minus the present value of all cash outflows (which equals the net present value) is greater than zero. Discount rate is a main input into the process that determines future cash flows to their present values.
The shareholders will expect an additional profit if the discount rate is equal their required rate of return (NPV > 0). The highest positive NPV should be chosen for maximizing shareholders wealth or if two projects are mutually exclusive. Net Present Value can be calculated according to the formula where t is the amount of time (usually in years) that cash has been invested in the project (in the case with CU Boxes Inc. it is 0); i the cost of capital; C the cash flow at that point in time and N the total length of the project (in this case, five years).
NPV = The company evaluating this investment using cash flow discounted at 10 % would compute an NPV of $ 137, 000. The result is decent but not spectacular. For more realistic picture other factors should be considered such as the calculation of taxes, uneven cash flows, and salvage values. Having examined pros and cons of three methods, the conclusion can be made that CU box, Inc.
should replace the old machine and the best way to analyze investment decisions is with the help of IRR, because it is good for short-term projects (less then 5 years) and is commonly used if a company will earn expanding or investing in itself. Bibliography: Capital budgeting needs vision. (2003). Business line. Islamabad: Jul 21, 2003. pg. 1 Financial Analysis of Major Projects. (2005).
CCH Incorporated. Wolters Kluwer business. Retrieved 2006 from web Frank, Lesley. (1997). Modified internal rate of return: Will it replace IRR?
Management Accounting. London, Vol. 75, Iss. 1; pg. 64, 2 pgs. Jay, Mike R. The Top 10 Things To Consider When Making A Capital Budgeting or Investment Decision. Coachville. Resource Center.
Retrieved Oct. 7, 1997 from web Net present value. Wikipedia. The free encyclopedia. web
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