Table of Contents
Executive summary
Introduction
Objectives of the project
Evaluation using DCF techniques
Decision Rule
Non-Financial Factors
Evaluation of the risks of the project
Recommendation
Conclusion
References
In capital budgeting, there are several appraisal methods and the
most common is the use of net present value analysis (NPV Analysis). The most
viable project to be undertaken is identified for capital budgeting process. In
this report, the managers of new look packaging limited want to expand the
capacity of production by importing a new machine MP-450. As a result, both the
quantitative and qualitative aspects of purchasing this new machine are
considered in this report. The use of NPV analysis and payback period has been
adopted to evaluate whether the project meets the required standards for
implementation. A suitable recommendation has been offered in the last section
of this report after the supporting calculations in excel.
The
payback period has also been factored in to establish whether the project meets
the minimum requirement by the directors of the company. This will ensure that
the project has the ability to recover the initial outlay in a timely manner.
The payback period is used along with the NPV and at times, together with the
internal rate of return.
There is only one alternative to choose from. The costs and
revenues over the 6 year period have been analyzed in the excel document. The
correct discount rate has been given at 18%. The appropriate decision is made
after considering the excel calculations.
Evaluation
using DCF techniques
Only the projects with a positive NPV should be accepted. If
multiple projects are being compared with positive NPVs then the one with the
highest NPV should be taken. If the NPV is zero, then the decision will be
indifferent. The payback period should be within the time frame stipulated by
the directors for the project to be viable. The MP-450 is indeed an income
generating machine with a reputation of great performance and easy handling
processes. The speed and the quality of cut realized by the other companies is
what the New Look Company needs. The MP-450 has also been credited of
durability and a lifetime service. Speaking of decision making what could the
company further consider with the current debts that the company is required to
repay? The NPV of MP-450 proofs a worth risk especially for a company looking
forward to making more profit with little or no withdrawals.
Capital budgeting techniques
The
investment appraisal process (also referred to as capital budgeting) is an
evaluation of the viability of a project based on the cash inflows and
outflows. This is useful in the determination of the equipments to purchase or
carry out an overhaul. Some of the applicable techniques are in capital
budgeting are:
Payback
Period- the payback period measures the time taken to recover the
initial outlay cost for the project. However, the cash flows are not
discounted and the lower the time period the better the project. The best way
to evaluate the payback time is through consideration of time factor,
efficiency, handling and maintenance. Based on the quality of work done by
companies using the MP-450 and their delivery time and maintenance costs, New
look is quite behind the grid. Utilizing the MP-450 might improve its services
hence shortening due to its efficiency and a workable payback period allowing
it to generate more income to the company.
Net
Present Value (NPV) - this technique makes use of
discounted cash flows net of the outflows from the project. Projects with a
positive NPV are considered. It’s beyond doubt that the new project is
promising to promote cash flow in the company following the many advantages
promised upon its installation. The aim of any business is to make profit,
meaning that any project promoting profits in the company should be considered
viable. The MP-450 in our case outweighs all possible doubts about promotion of
income in the company justifying its viability.
Accounting
Rate of Return (ARR) This is a non discounted cash flow analysis technique that
factors in the residual income after deducting the cost of the project. This
provides a useful analysis on the profitability of the project from an
accounting perspective. The new look company is enormous with a branch count of
120 and realization of big returns yearly. Investment on a new machine is like
drop in the ocean though a withdrawal in the company’s accounts. The only
motivation accompanied by the investment is the fact that in the long run the
company is assured of huge profits. The machine purchase has very little impact
on the company’s accounts and in the package great returns are assured.
Internal
Rate of Return (IRR) this is the discounting rate that equates the net present
value of the system to zero. A higher rate for IRR is considered for
undertaking
Profitability
Index (PI) is the ratio of present value of future cash flows of a
project to initial investment required for the project. The investment assures
the company of improvement in profit both currently and the future despite the
small investment.
With increased capacity, the quality of the product should not be
compromised since this will make the customers resort to other substitutes
available in the market. In addition, it is important to consider the external
environment of the project. Extreme environmental conditions will make the
project unsuccessful in the installation and operation. It is important to
consider the local competition and establish the impact of the new machine on
the market. In addition, the availability of skilled operators for the machine
should be considered. At times, it might be necessary to send support from the
country of origin to help with the installation and training of workers on how
to operate, repair and maintain the machine. The machine has little or no
altering effect on the products, and its application is easy to understand
through clearly stated instructions hence eliminating investment on more
qualified staff.
Evaluation of the risks of the project
Some of the risks facing the project include the rising
inflationary trends. The cash flows should therefore be adjusted to reflect the
rate of inflation in the country. Investing in countries with high inflation
rates is risky. In such a country, the currency conversion will be affected
adversely. In addition, changes in the cost of capital also make the project
uncertain. The values used in the NPV calculation are estimates and this can
create a variance with the actual figures. The variables will create uncertainty
especially on the salvage value and the discounting rate applied. Furthermore,
the political environment can have an impact on the importation of the machine.
There can be heavy import duty taxes that will have an impact on the decision
that will be made. Unstable cash flows can result from political unrests.
Stable political environment will be better for efficiency in running the
project.
I highly recommend this project following its great qualities and
little maintenance and expenses needed once the project commences.
It is economical to undertake this project. The MP-450 has a positive NPV and
this qualifies in the decision criteria to undertake the project. The
management should consider the non-financial factors discussed above. The
required discounted payback period is 4 years and this new project will repay
its initial outlay in less than three years. This makes the project viable and
capable of making a repayment on the initial cost of purchasing it within the
required time frame. With the above recommendations catered for the company
stands a chance to pay its huge debts and make great profits it’s the
future.
Due to the scarce nature of resources, the capital budgeting
decisions should be, made with a careful approach. As a result, the use of cash
flows that are discounted will provide a great insight into the decisions to be
made by the management. The purchase of MP-450 is a worthwhile decision due to
the increased cash flows and the ability to improve the competitive ability of
the company.
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