The financial feasibility of a capital expenditure. Pevensey Plc - Essay Example

?Pevensey Plc is in the process of evaluating the financial feasibility of a capital expenditure which pertains to the purchasing decision of a machine. The procurement department of the company after careful deliberation and consideration have short listed four machines which are suitable and possess all the required functionalities. The head of the production department has approved all the short listed machines and now the decision rests with the financial control unit in order to evaluate the financial feasibility of the purchasing decision. Future cash flows have been forecasted and are presented as net cash inflows. The cash outflows comprises of expected repair and maintenance expenditure over the useful life of the asset. Whereas, the cash inflows includes the expected total revenue generated by the machines in the form of sale of the products manufactured by the machine. All the projected cash flows include the impact of expected inflation. The capital expenditure pertaining to the purchase of machine has been decided to be funded through internally generated funds. Therefore, keeping into consideration the limited amount of the funds, the directors of the company must make prudent investment decision so to achieve the most lucrative and appropriate results. The method used in the investment appraisal is determining the Net Present Value (NPV) of each proposal. According to this method, the future expected cash flow, over the time span of the project, are discounted based on the expected discount rate in the economy. As per the treasury department of the company, the cost of capital of the company is 9%, which is used as the discount rate in calculating the NPV of each project. The expected cash flow from each year is multiplied by the discount factor to arrive at the present value at year 0 i.e. at the time of making of the capital expenditure. An investment whose NPV is positive is considered to be a rewarding one, whereas an entity does not venture on an investment where the NPV of the cumulative cash flows is negative. Where the management has to rank the investments, with the objective of giving priority to the most rewarding ones, the investment with the highest NPV must be ranked first. Calculating Internal Rate of Return (IRR) is another method extensively used in the investment appraisals. IRR is a rate where the cost of investment, cash outflow, is equal to the cash inflows. The proposal with the highest IRR is considered to be the most rewarding one. Payback period is another method utilized in investment appraisal which calculates the time taken by the investment to generate enough cash inflows to recover the initial cost of the investment. Investment appraisal through NPV method and IRR method are both very useful in order to financially attractive prospective of any investment decision. A good financial analysis is based on the trade off between these two methods. However, practically the IRR method is used widely in investment appraisal decision. The prime reason behind selecting the IRR method of appraisal is it is comparatively straight forward and can be used without having a prior experience in capital budgeting. NPV method has certain drawbacks and limitations. Different projects must be assessed at different discount rates because the risk for each project is generally different. The reliability of the NPV based investment appraisal can be as reliable as the discount rate itself. However, in practice, it is very unrealistic to determine different discount rate for different investment proposals. Whereas, IRR uses a single discount rate to evaluate every investment, due to which it is used extensively among the financial analysts. With certain disadvantages, the NPV method comes with several attributes which makes it superior to the IRR method. IRR method of appraisal is for evaluating the financial result of an investment over a short period of time. Moreover, IRR is also ineffective for investments proposals which are a mixture of positive and negative cash flow. For these types of investments, the IRR can be more than one. Another factor which makes the NPV method more reliable than the IRR method is the fact that the discount rate changes several time over the period. The IRR method does not incorporate this fact into calculation, and thus is not suitable for long term investment appraisal. In NPV method the discount rate is known and is singular which makes it easier to evaluate the feasibility of the investment. An investment with a negative value represent an unattractive investment where as a positive value represents otherwise. In IRR method, the rate must be compared to a specified risk rate in order to declare the investment proposal effective or ineffective. In the absence of the predetermined risk rate, the IRR method is of no use. Based on the discussed fact, NPV method of appraising investment is more practical and precise. Appendix A represents the evaluation of machine using NPV analysis method. As per this evaluation methodology, acquisition of machine D is the financially viable decision. As apparent from the calculation, machine D has the highest NPV of all amounting to ? 22.35 thousands. This figure means that the value of the future benefits to be reaped from the acquisition of the machine, is at presents amounts to ? 22.35 thousands, keeping into consideration the time value of the money. The discount rate used in the calculation is 9% which is the company cost of capital. Since the company has decided to utilize its own funds in order to finance this capital expenditure, the cost of capital represents the cost of equity of the company. Cost of equity, further, can be translated as the shareholders desired rate of return. It can be further noted that the acquisition of machine D results in the highest capital outlay at time 0 amounting to ? 140 thousands but the analysis show that this decision will benefits to the company in the form of higher cash flows. Investment in Machine C must not be made under any circumstances as its NPV is negative which can be translated as this investment decision will eventually bring cash outflow from the company. The discounted factor is calculated through the formula S = P x (1+i) ^n Where S is the future value of any cash flow, P is the present value of the cash flow at time ‘0’, i is the discounting rate which is the cost of capital of the company and n is the number of years from time ‘0’. Appendix B includes evaluation of the investment decision based on IRR technique. As per the IRR technique, acquisition of machine B is the most profitable one as it has the highest IRR of 17.28% followed closely by machine A with IRR of 17.13%. Appendix C includes evaluation of the investment decision based on the payback period. As per the payback period of evaluation of investment appraisal, the best investment decision is to acquire machine B which paybacks the initial capital outlay in 2.63 years which is the lowest out of all followed by machine A which paybacks the initial capital outlay in 3.5 years from the time of the initial investment. Machine ‘A’ which turned out to be the best choice as per NPV analysis, has the highest payback period of 4.20 years. Based on the above investment appraisal techniques, it is in the best interest of the company to acquire Machine B as it has the highest IRR and lowest payback period out of all the options. NPV analysis in this case is not a suitable technique as it requires various judgements, estimation and uncertainties pertaining to the cost of capital of the company, future inflation rates and expected repair and maintenance decisions. While making an investment appraisal decision, it is imperative to consider the impact of inflation in the future cash flow. The data gathered by the relevant departments does not include any relevant information about the price inflation over the five year period which can significantly impact the expected rate of return. The director must also consider the sources from which the financing will be obtained for the investment. Financing decision is significant as the company would have to pay finance charge to the bank or any other financial institution, and the company must have enough cash flows in the future for the payment of these finance charges. In order to commence any investment venture, the director must take approval of the shareholders. Although certain investment might appear to be rewarding and worthwhile to invest, do not get shareholders attention that easily. Shareholders, who are often short sighted and tend to ignore the long term feasibility, disapprove the decision of the board based on the fact that the cost of investment will weaken the financial outlook of the organization in the year of the investment. The director while making the investment decision must keep into consideration whether it is of a capital nature or would be reflected in the profit and loss of the company as an expense. Creation of a formal staff training system and introduction of approved quality assurance scheme would cast impact on the profit and loss statement and would decrease the profit for the year. Appendix A NPV Method of Valuation (All figures in ?000) - Cost of Capital is 9% Machine A Machine C Years Cash Flows Discounting Factor NPV Years Cash Flows Discounting Factor NPV 0 -80 1.000 (80.00) 0 -120 1.000 (120.00) 1 15 0.917 13.76 1 25 0.917 22.94 2 25 0.842 21.04 2 35 0.842 29.46 3 25 0.772 19.30 3 40 0.772 30.89 4 30 0.708 21.25 4 20 0.708 14.17 5 30 0.650 19.50 5 10 0.650 6.50 6 10 0.596 5.96 6 10 0.596 5.96 Total NPV 20.82 Total NPV (10.09) Machine B Machine D Years Cash Flows Discounting Factor NPV Years Cash Flows Discounting Factor NPV 0 -100 1.000 (100.00) 0 -140 1.000 (140.00) 1 35 0.917 32.11 1 10 0.917 9.17 2 40 0.842 33.67 2 20 0.842 16.83 3 40 0.772 30.89 3 50 0.772 38.61 4 15 0.708 10.63 4 50 0.708 35.42 5 10 0.650 6.50 5 50 0.650 32.50 6 10 0.596 5.96 6 50 0.596 29.81 Total NPV 19.75 Total NPV 22.35 Appendix B IRR Method of Valuation (All figures in ?000)     Machine A   Machine C   Years Cash Flows Years Cash Flows 0 -80 0 -120 1 15 1 25 2 25 2 35 3 25 3 40 4 30 4 20 5 30 5 10 6 10 6 10 IRR 17.13% IRR 5.58% Machine B   Machine D   Years Cash Flows Years Cash Flows 0 -100 0 -140 1 35 1 10 2 40 2 20 3 40 3 50 4 15 4 50 5 10 5 50 6 10 6 50 IRR 17.28% IRR 13.20% Appendix C Payback Method of Valuation (All figures in ?000)       Machine A     Machine C     Years Cash Flows Cumulative Cash Flow Years Cash Flows Discounting Factor 0 (80)   0 (120)               1 15 15.000 1 25 25.000 2 25 40.000 2 35 60.000 3 25 65.000 3 40 100.000 4 30 95.000 4 20 120.000 5 30 125.000 5 10 130.000 6 10 135.000 6 10 140.000 Payback between Year 3 and 4 Payback between Year 4 Difference in cumulative cash flow 30 Difference in cumulative cash flow - Fraction   0.50 Fraction   - Payback period (Years) 3.50 Payback period (Years) 4.00 Machine B     Machine D     Years Cash Flows Discounting Factor Years Cash Flows Discounting Factor 0 (100)   0 (140)               1 35 35.000 1 10 10.000 2 40 75.000 2 20 30.000 3 40 115.000 3 50 80.000 4 15 130.000 4 50 130.000 5 10 140.000 5 50 180.000 6 10 150.000 6 50 230.000 Payback between Year 2 and 3 Payback between Year 4 and 5 Difference in cumulative cash flow 40 Difference in cumulative cash flow 50.00 Fraction   0.63 Fraction   0.20 Payback period (Years) 2.63 Payback period (Years) 4.20 References [1] Linda Grayson “Internal rate of return: An inside Look” investopedia.com. Investopedia, n.d. Web. 08 March. 2012. [2] “Net Present Value - NPV” investopedia.com. Investopedia, n.d. Web. 08 March. 2012. [3] Elazar Berkovitch “Why the NPV Criterion does not maximize NPV” rfs.oxfordjournals.org Oxford Journals n.d. Web. 08 March. 2012. [4] Randika Lalith Abeysinghe “Nature and introduction of investment decision” ezinearticles.com Ezine articles n.d. Web. 08 March. 2012. [5] “What influences investment decision” saching.com saching.com n.d. Web. 08 March. 2012. [6] “Which is a better measure for capital budgeting, IRR or NPV.” investopedia.com. Investopedia, n.d. Web. 08 March. 2012. Read More