Purchase decision of Pevensey PLC among four options of machinery - Essay Example

? Table of Contents Introduction 3 Analysis 3 Risks and Problems Associated with the Analysis 6 Conclusion 6 Recommendation 6 References 7 Appendices8 Appendix 1 – Non-Discounted Cash Flow Analysis 8 Appendix 2 – Discounted Cash Flow Analysis 8 Introduction The structured business report pertains to the organization Pevensey PLC. The report appraises a project using discounted and non-discounted cash flow techniques for selection of a machine among four options. The criterion for decision making is purely objective based on the projected cash flow generated by each machine and its respective salvage value. In this case, the purchase decision machinery relates to discounted and non-discounted cash flow analysis of cash flow from four machines. The paper attempts to find the optimizing solutions by weighing respective costs and benefits of each machine. Analysis is explained in detail in the paper since the paper is addressed to the Board of Directors of the company. Analysis Two methods for analysis of the investment decision are adopted in this paper. These methods include discounted and non-discounted cash flow analysis. The reason for choosing these particular methods is that they are strictly numerical and objective. The solution given by these methods cannot be argued against and can be easily defended if questions are raised pertaining to their legitimacy. Relevant data is also available for using the above mentioned methods of analysis. The initial costs of the four machines, their residual value at the end of their useful life and cash flow generated by the four machines is provided in the case. Non-Discounted Cash Flow Analysis Non-Discounted Cash flow simply calculates the differential between the costs and receipts associated with each investment option for the organization. In this particular case, the investment options for the company are the four machines (Ward, 1978). The benefit of non-discounted cash flow method is ease of assessment and communication to the top management (Plewa and Thomas, 1995). For this particular case of the four machines, the decision criterion for selection of a machine is the difference between revenues of the machines and its cost. The machine with greatest positive difference between costs and revenues would be selected for the purchase, while the one with negative value is not feasible at all. The cost of machine A, B, C & D is 80000, 100000, 120000 & 140000 respectively. While the revenues generated by the four machines is 135000, 150000, 140000 & 230000 respectively. The difference between these figures can be calculated very readily. These differences are represented in the table below: Machine A Machine B Machine C Machine D 55 50 20 90 The above mention table exhibits that investment in all four machines is profitable for Pevensey PLC - cost of purchasing the machinery for all four cases is lesser than the sum of the revenue generated by them (revenues comprising of their production and the residual value of sales after their useful life). Machine D stands out with the greatest net benefit of $90,000 to Pevensey PLC. Hence, the non-discounted cash flow analysis states that Machine D should be purchases by the organization. Discounted Cash Flow Analysis Discounted cash flow is a modified and improved version of cash flow analysis in which timings of the cash flows are also taken into account. Under this method, value for each cash flow is discounted according to respective cost of capital of the company (Aoun and Hwang, 2008). This method makes more sense because contemporary organizations prefer gain cash flow as early as possible, so that this cash flow can be reinvested in the business or some other venture. Aversion to risk is the second reason for discounting of because the distant is the date for receipt for cash; the lesser is the certainty of receiving it. An investment is viable if its net cash inflow exceeds the net outflow of cash for acquisition and maintenance of machinery (Gilchrist and Himmelberg, 1995). The cost of capital of Pevensey PLC is given as 8 percent. Therefore, all the cash flows of the company are discounted by a factor of 8 percent. In this analysis, the value of each flow decreases according to the distance of the time at which it is received. The farther a cash flow, the lesser is its attractiveness for Pevensey PLC. A sample of Machine B’s cash flow is shown below to exhibit the impact of discounting. Cash Flow Discounted Cash Flow -100 -100 35 32 40 34 40 32 15 11 10 7 10 7   18 As it can be seen, the true value of $40,000 cash flow is $33,000 because it is received after two years. Similar discounting is done for cash flows of all machineries. The discounted cash flow for each is calculated by adjusting to reflect the value of money over time. This is a major criterion when it comes to evaluating or comparing machine acquisitions. Among for four machine options of Pevensey PLC, discounted cash flows (at a discount rate of 8%) are used to relatively weigh different alternatives of machinery purchase (Plewa and Thomas, 1995). The method of discounting cash flows is very effective for this problem because it allows comparing values even when cash flows fluctuate.  Machine A Machine B Machine C Machine D Net Cash Flow 24 23 -7 31 The finding of the above mentioned analysis shows that the company will incur a loss by investing in Machine C. This is because Machine C’s cash flow is negative when the cost of capital of the organization is taken into account. Therefore, investment in Machine C should not be made at all. The highest value of positive cash flow is associated with Machine D according to discounted cash flow analysis. It shows that this machine is most profitable for Pevensey PLC. Risks and Problems Associated with the Analysis The board of directors must be cognizant of the assumptions taken in this analysis. During both discounted and non-discounted cash flow analysis, it was assumed that the cash flow for each year is received at the end of each year. The cost of capital of Pevensey PLC is assumed at 8 percent. Corporate tax rate of the company is not taken into this account during the analysis. The problems with these assumptions it that the cost of capital of Pevensey PLC might change and the relative importance of cash flow which is generated at different time periods can be altered (Hirth and Viswanatha, 2011). The second problem with the solutions is that the method does not take into account the timing of the cash flow; rather only the value is taken into account. Conclusion The report is based on purchase decision of Pevensey PLC among four options of machinery. It is concluded that Machine D is the most profitable investment choice for Pevensey PLC, because the difference between the cost and revenues of the machinery is greatest for this machinery using both non-discounted and discounted cash flow as calculation methods. It is also concluded that the advantage of non-discounted cash flow technique for evaluation of a project or machinery is that it is simple to calculate and easy to explain to organizational members. Using non-discounted methods, the net cash flow for investment for all four machineries is positive because the cost of purchasing the machinery for all four cases is lesser than the sum of the revenue which is generated by them over the course of their useful life. It is acknowledged that non-discounted method does not take into account the timing of the cash flow; rather only the value is taken into account. Recommendation The recommendation for Pevensey PLC is to invest in Machine D. This recommendation is based on both discounted and non-discounted cash flow analysis. References Aoun, D. and Hwang, J. (2008) 'The effects of cash flow and size on the investment decisions of ICT firms: A dynamic approach', Information Economics and Policy, vol. 20, no. 2, pp. 120-134. Gilchrist, S. and Himmelberg, C. (1995) 'Evidence on the role of cash flow for investment', Journal of Monetary Economics, vol. 36, no. 3, pp. 541-572. Hirth, S. and Viswanatha, M. (2011) 'Financing constraints, cash-flow risk, and corporate investment', Journal of Corporate Finance, vol. 17, no. 5, pp. 496-509. Packard, P. (1990 ) Cash flow analysis, New Jersey: Cardinal Stritch College. Plewa, F. and Thomas, G. (1995) Understanding cash flow, Ohio: John Wiley & Sons. Ward, T. (1978) 'Discounted cash flow analysis of time series', Computers & Industrial Engineering, vol. 2, no. 2, pp. 55-66. Appendices Appendix 1 – Non-Discounted Cash Flow Analysis Year (all amounts in 000's) Machine A Machine B Machine C Machine D 0 -80 -100 -120 -140 1 15 35 25 10 2 25 40 35 20 3 25 40 40 50 4 30 15 20 50 5 30 10 10 50 6 10 10 10 50 Net Cash Flow 55 50 20 90 Appendix 2 – Discounted Cash Flow Analysis Year (all amounts in 000's) Machine A Discounted Value Machine B Discounted Value 0 -80 -80 -100 -100 1 15 14 35 32 2 25 21 40 33 3 25 19 40 30 4 30 20 15 10 5 30 19 10 6 6 10 6 10 6 Net Cash Flow   18   18 Year (all amounts in 000's) Machine C Discounted Value Machine D Discounted Value 0 -120 -120 -140 -140 1 25 23 10 9 2 35 29 20 17 3 40 30 50 38 4 20 14 50 34 5 10 6 50 31 6 10 6 50 31 Net Cash Flow   -12   19 Read More