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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.
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.
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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