Viability of new equipment
The proposed acquisition of new manufacturing equipment has been assessed using various capital budgeting tools. The tools used to evaluate the viability of the project are the payback period, net present value, and internal rate of return, and modified internal rate of return. The following analysis explains their use, criteria for accepting/rejecting the project, and my recommendation about the project:-
Payback Method
This method measures the length of time it will take for a business to recover the investment made. The measure uses the initial cash investment made and the average annual net cash flow. Dividing the former by the latter, the result is a number that represents the cash payback period in the number of years. The formula is:
Cash Payback Period = Capital Investment
Average Annual Net Cash Flow
It is normal to average the annual cash flow since it is usual to see that cash flows are not constant through the period of the active performance of the capital assets obtained through the investment made.
The shorter the payback period the sooner the company recovers its cash investment. However, the adequacy of the payback period is dependant on the perceptions of the firm, the type of industry or service, and the macro and microeconomic conditions. The payback period is usually considered viable if it is between 2 and 3 years. In some projects, in the initial period, the cash flows fluctuate vastly and may even be negative at the start. In such cases, the cumulative net annual cash flow helps determine the time for the recovery of the investment.
In this case, the payback period is 2 years and 11 months. The project is acceptable since the payback period is less than the life of the project.
This method suffers from the limitation that it does not factor in the differences in cash flows due to their timing or the time required for the execution of the project. For example, two projects may require the same investment and have the same payback period, but the timing of the cash flows may be quite different. In such a case, the project that yields quicker net cash flows is preferable over the other.
Net present value
This method considers time value for money. It is calculated as shown below.
Net present value = present value of cash inflows – net investments
The criteria for accepting rejecting the project is if NPV ≥ 0 accepts the project otherwise rejects the project. The project is accepted when the NPV ≥ is 0 is because it will increase the shareholders’ wealth. In this case, the net present value for the project is $ 150,768, this project generates a positive net present value therefore the management should accept it.
Internal Rate of Return (IRR)
This method also relies on the concept of calculation of present values. The IRR determines the interest yield of the capital project at which the net present value becomes zero. Returning to the NPV calculation, we note that a discount rate, based on the needed rate of return of the business, determines the present value of future cash flows. In the case of IRR calculations, the reverse is true, the rate is calculated using the net future cash flows and the IRR is the rate at which the discount will bring the net cash flow to zero, i.e. the present value of the net cash flows and the investment required are the same. Where the IRR is greater than the expected return or the cost of funds the project is financially viable and projects with higher IRR are more viable (Westerfield R., Jaffe, and Jordan, 2007). Therefore, the internal rate of return is the rate of discount that causes the present value of cash inflows to be equal to the net investment value of the project that is the rate that produces 0 net present values (McLaney E., (2003). The criteria for accepting and checking the project is that internal rate of return ≥ cost of capital the project is accepted otherwise the project is subject to rejection. Calculation of the IRR requires two steps. The first step is to calculate the internal rate of return factor using the formula (Westerfield R., Jaffe, and Jordan,2007):- This can be summarized as follows:
- Annuity: calculate the payback period of the project and Use the present value annuity factor table to find the factor closest to the payback period. This could produce an internal rate of return.
- For the mixed stream of cash flows:- Calculate the average annual cash flow to get a fake annuity and divide by average annual cash flow into initial net investment in order to get a fake payback period.
- The simpler method is to use spreadsheet software such as Microsoft Excel that allows direct calculation of the IRR from a table of projected cash flows.
Modified internal rate of return
The modified internal rate of return is similar to IRR but goes ahead to eliminate the weaknesses of the IRR. The weakness of IRR eliminated by MIRR is reinvestment rate and multiple IRR. MIRR assumes that the rate at which funds are reinvested is at the cost of capital i.e equivalent weighted average cost of capital for corporate. It also avoids the problem of Multiple IRR that requires simulation to have probabilities that will estimate (ACCA,2008).
This method is superior to the IRR and NPV AS well as the Profitability index. This method is calculated as follows;
- Calculate all the cash flows
- Determine all future values of cash flows at the last of the project.
- Calculate the rate that makes the future value determined to be equal to zero.
This will give the value of MIRR. The Criteria for accepting for the project is that when MIRR is greater than or equal to the cost of capital accept the project (ACCA, 2008).
Formula
Initial investment = Future Value
(1+MIRR)N
Net investment 1,300,000, useful life 5 years, annual cash inflows 500,000 for year 1, year 2 350,000, year three 475,000, year four 450,000 and year five 300,000 and discount rate 6%. The modified internal rate of return of the project is 17%. Therefore I recommend that the should be undertaken as it gives a higher Modified internal rate of return than the weighted average cost of capital that is 17%(MIRR) ≥ 6%(WACC).
Conclusion
Using the all tools analyzed above, the is acceptable and should be undertaken. The methods have helped us to understand the investment proposal from different angles by determining its viability and future economic performance. Lastly, the best method among the four methods is MIRR since it considers reinvestment and avoids the multiple rates and it also leads to accepting the project.
References
- ACCA ; (2008); Modified internal rate of return relevant to ACCA QUALIFICATION paper.
- McLaney E., (2003; Business finance theory and practice; Prentice-Hall ISBN 0-273-67356-4.
- Schlosser M.;(2002); Business finance: application, Models and cases, prentice hall, ISBN 0-13-264649-8.
- Westerfield R., Jaffe, and Jordan (2007); Corporate finance core principles and applications by McGraw-Hill. ISBN-13: 978-0-07-353059-8/ISBN-10:0-07-353059-X