Appraisal Of Capital Investment Decisions Essay

Question:

Discuss about the Appraisal of Capital Investment Decisions.

Answer:

Introduction

The capital investment decisions involve huge sum of money therefore it is of paramount importance for the management to make these decisions after carrying out the analysis effectively. There are various tools and techniques being applied for the purpose of analyzing the financial viability of a capital investment, the most prominent among them is the net present value technique (NPV) (Atrill and McLaney, 2008). The other techniques involve internal rate of return (IRR), payback period, and accounting rate of return. In this context, the report presented here provides discussion on various techniques of capital investment analysis such as NPV, IRR, Payback period etc. Further, the report also demonstrates the practical application of NPV technique in analyzing the machine replacement decision (Atrill and McLaney, 2008).

Watley’s is considering replacing the old machine with the automated new machine which is expected to reduce the manufacturing cost to a large extent over the period of four years. The machine will initially cost ?60,000 and require a sum of ?2,000 being incurred per year on maintenance. The new machine is expected to reduce the manufacturing labor cost by ?22,000 for four years. In order to analyze that whether this replacement decision would be financially worthwhile or not, the NPV has been computed as below:

NPV of Project

Year

Cash Flows

[email protected]%

PV

0

(60,000.00)

1.000

(60,000.00)

1

20,000.00

0.909

18,181.82

2

20,000.00

0.826

16,528.93

3

20,000.00

0.751

15,026.30

4

20,000.00

0.683

13,660.27

NPV

3,397.31

It can be observed from the computations shown in the table given above that the NPV of replacement is ?3,397.31. The positive NPV of replacement decision reflects that it would be worthwhile to implement the replacement of the machine. Thus, it is advised that the company should go for replacement of old machine with the new automated machine.

There are three crucial elements found in any capital investment decisions such as cash inflows, outflows, and discount rate. In order to compute cash inflows, outflows, and discount rate, there are made a number of assumptions. The capital investment decision is futuristic and thus, assumptions are made about the future outlook in respect of these three crucial elements (R?hrich, 2014). The computation of cash inflows requires estimation about the sale units and unit price. Similarly, estimations are made in respect of costs to arrive at the cash outflows. Further, the determination of discount rate requires various assumptions about the risk and expected return of the investors (R?hrich, 2014).

The discounting of cash flows is normally done at the desired rate of return of the investors which in the case of a company is taken as WACC. Further, the computation of WACC is based on the estimations of cost of equity and after tax cost of debt. The estimation of cost of debt is however simple and requires less assumptions but the same is not the case with cost of equity. The cost of equity is computed based on various assumptions, for example, assumption about future dividend payment, growth rate, risk free rate, and market risk premium. Further, the assumptions are also required to be made about the life span of the project in which capital investment is being made (R?hrich, 2014).

In regards to the replacement of old cutting machine with the new automated machine, the two crucial assumptions are savings in the labor cost and useful life of machine. It has been assumed that the new machine will cause savings in the labor cost of ?22,000 annually. Further, it has been assumed that the machine will require annual maintenance incurring a sum of ?2,000. These assumptions are based on the initial estimates only and thus, there always remains possibility of variance (Drury, 2008). It may be possible that the maintenance cost is increased in future and thus, the company may incur additional money or it may decrease also resulting in increase in savings. Further, it has been assumed that the new machine will be in a workable condition for 4 years. However, it may or may not or it may end up with more years (Drury, 2008).

It is essential to note that the assumptions should be made in such a way that the possibility of variance is reduced. If the assumptions are made precisely, the possibility of achieving the desired outcome is increased. For example, if the life of new machine is not estimated precisely and suppose if the machine is retired from use after three years, the resultant NPV would be less than ?3,397.31 which might make the replacement decision less attractive. Thus, it is crucial to make the assumption precisely considering the past and future performance (Chapman, Hopwood, and Shields, 2011).


It has already been discussed that there are various capital investment appraisal method/techniques. Some of them involve the use of time value of money and some do not. For example, the NPV and IRR techniques use the concept of time value of money while the payback period and accounting rate of return are the techniques that do not implicate the use of time value of money (Chapman, Hopwood, and Shields, 2011).

The net present value technique requires the calculation of present value of net cash inflows and comparing the same with the initial capital outlay. If the initial capital outlay is less than the present value of net cash inflows, the NPV is positive and hence the project becomes acceptable. On the other hand, if the initial capital outlay is greater than the present value of net cash inflows, the NPV is negative and hence the project is liable to be rejected. Keeping the NPV aside, the project can also be appraised using the IRR technique. The internal rate of return is the breakeven return that the project must earn in order to be called financially worthwhile. The internal rate of return is compared with the cost of capital and if the IRR is greater than the cost of capital, the project is accepted else it is rejected (Chapman, Hopwood, and Shields, 2011).

The internal rate of return technique is also widely used but it suffers from certain limitations which restricts its use in the special circumstances. For instance, when the series of cash flows involves cash outflows at more than one occasion, it may result in multiple IRRs giving conflicting views (Gotze, Northcott, and Schuster, 2016). However, when it comes on comparing more than one mutually exclusive project with each other; the IRR is considered better than NPV. Further, the payback period is also used in analyzing the financial viability of the project. The payback period computes the time duration within which the amount of initial investment would be recovered. In most of the cases, the payback period method is used in conjunction with other methods such as NPV and IRR. The payback period used singly in analyzing the project’s financial worth would be less useful (Gotze, Northcott, and Schuster, 2016).

In the current case, there is single project under consideration. The financial viability of a single project could be assessed applying any of the three methods such as NPV, IRR, and payback period. The results of all three methods would lead to same conclusion about acceptance or rejection of the project. The NPV method has been applied in assessing that whether the replacement decision is financially worthwhile or not. If the IRR or payback period is applied, the result would be same i.e. the project would be acceptable (Gotze, Northcott, and Schuster, 2016).

Conclusion

In analyzing the project’s financial viability, the management of the company may consider applying a number of methods such as NPV, IRR, and payback period. The management should consider that these methods have different characteristics and some specific situations may require use of specific method. However, the NPV method is commonly applied and it is considered as one of the most appropriate and suitable to all conditions method. In analyzing the replacement decision of Watley, the NPV method has been applied which shows a positive NPV of ?3,397.31.

References

Atrill, P. and E. J. McLaney. 2008. Accounting and Finance for Non-specialists. Prentice Hall Financial Times.

Chapman, C.S., Hopwood, A.G., and Shields, M.D. 2011. Handbook of Management Accounting Research. Elsevier.

Drury, C. 2008. Management and Cost Accounting. Cengage Learning EMEA.

Gotze, U., Northcott, D. and Schuster, P., 2016. Investment appraisal. Springer-verlag berlin an.

R?hrich, M. 2014. Fundamentals of Investment Appraisal: An Illustration based on a Case Study. Walter de Gruyter GmbH & Co KG.

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