Calculation: Capital Cost
The Allied Group is considering two investments. The first investment involves a packaging machine, which can be used to package garments for shipping orders to customers. The second possible investment would be a molding machine that would be used to mold the mannequin parts.
The first possible investment is the packaging machine, which will cost $14,000. The second investment, the molding machine, would cost $12,000. The expected cash flows for the two projects are given below and the cost of capital to the firm is 15%. Both machines will be unusable after five years and have no salvage value.
The net cash flows for the two possible projects are given in the following table:
Year Packaging Machine Molding Machine
0 ($14000) ($12,000)
1 4100 3200
2 3300 2800
3 2900 2800
4 2200 2200
5 1200 2200
Questions: Address all of the following questions in a brief but thorough manner.
- What is each project’s payback period? Provide a detailed explanation of how you calculated the payback period for each.
- What is the NPV for each project? Provide a detailed explanation of how you calculated the payback period for each.
- What is the IRR for each project? Provide a detailed explanation of how you calculated the payback period for each.
- If both of the projects can be selected, then should both be selected? Why or why not? Explain why or why not.
- If the two projects are mutually exclusive, which project, if any, should be selected? Explain why.
Solution
Introduction: Capital budgeting decision is always a complex process. At any given time firm has limited resources while there are multiple investment opportunities. Such opportunities could be buying a new machinery, entering a new market, launching a new product or any other investment requirement. Therefore, firm need to follow a rational and scientific approach to select the opportunity so that the benefit of the firm can be maximized. There are multiple framework which used in capital budgeting, including the techniques such as payback period, net present value (NPV), internal rate of return (IRR), accounting rate of return etc. However, the scope of the work is limited to the calculation of payback period net present value (NPV), and internal rate of return (IRR) (Johnathan, DeMarzo, and Stangeland, 2015).
Project’s payback period: Payback period is a capital budgeting toolwhich refers to the period of time required to recoup the funds expended in an investment. It does not consider the time value of money. Lower the project’s payback period is better the project is for the organization(Pogue, 2004).
The cash-flow associated with the two projects are as follows:
First Investment: Involves a packaging machine, which can be used to package garments for shipping orders to customers
Year 0 | Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | |
Cash flows | $ -14,000.00 | $ 4,100.00 | $ 3,300.00 | $ 2,900.00 | $ 2,200.00 | $ 1,200.00 |
Total outflow during project lifecycle is $ 14,000 while total inflow is only $13,700. Therefore, payback period of the project is more than 5 years i.e. project could not achieve breakeven during the mentioned lifecycle.
Second investment:Moulding machine that would be used to mould the mannequin parts.
Year 0 | Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | |
Cash Flows | $ -12,000.00 | $ 3,200.00 | $ 2,800.00 | $ 2,800.00 | $ 2,200.00 | $ 2,200.00 |
Total outflow during project lifecycle is $ 12,000 while total inflow during 5 years is $13,200 while during 4 years is $11,000, which means $1,000 need to be recovered in Year 5. Since cash inflow of fifth year is $ 2,200 which means every month cash inflow would be $183.33. So, for recovering another $1,000, it would take 0.455 months i.e. 13.65 days. So payback period is 4 years 5 months and 14 days.
Since payback period of investment in moulding machine is lower than that of investing in packaging machine, therefore investing in moulding machine that would be used to mould the mannequin parts may be considered
Net present value:Net present value is defined as present value of all future cash flows. Therefore net present value considers the time value of money. It discounts all future cash flow with opportunity cost which is generally weighted average cost of capital. Higher the project’s net present value is better the project is for the organization (Pogue,2004).
First Investment: Involves a packaging machine, which can be used to package garments for shipping orders to customers.
Year 0 | Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | |
Cash flows | $ -14,000.00 | $ 4,100.00 | $ 3,300.00 | $ 2,900.00 | $ 2,200.00 | $ 1,200.00 |
Discount Factor | 1.000 | 0.870 | 0.756 | 0.658 | 0.572 | 0.497 |
Discounted Cash flow | $ -14,000.00 | $ 3,565.22 | $ 2,495.27 | $ 1,906.80 | $ 1,257.86 | $ 596.61 |
NPV | $ -4,178.24 |
Second investment:Moulding machine that would be used to mould the mannequin parts.
Year 0 | Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | |
Cash Flows | $ -12,000.00 | $ 3,200.00 | $ 2,800.00 | $ 2,800.00 | $ 2,200.00 | $ 2,200.00 |
Discount factor | 1.000 | 0.870 | 0.756 | 0.658 | 0.572 | 0.497 |
Discounted Cash flow | $ -12,000.00 | $ 2,782.61 | $ 2,117.20 | $ 1,841.05 | $ 1,257.86 | $ 1,093.79 |
NPV | $ -2,907.50 |
Both projects have negative net present value which means neither of them has the potential to create value for the firm. Therefore both project should not be accepted. However, if there is any requirement to accept at least one project, investment is moulding machines may be considered as it has higher net present value.
Internal rate of return:The internal rate of return on an investment or project is the “annualized effective compounded return rate” or rate of return that sets the net present value of all cash flows (both positive and negative) from the investment equal to zero. Higher the internal rate of return, better the project is. If internal rate of return is higher than the cost of capital, then the project would add value for the firm (Magni, 2010).
First Investment: Involves a packaging machine, which can be used to package garments for shipping orders to customers.
Year 0 | Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | |
Cash flows | $ -14,000.00 | $ 4,100.00 | $ 3,300.00 | $ 2,900.00 | $ 2,200.00 | $ 1,200.00 |
IRR | -0.9% |
Second investment:Moulding machine that would be used to mould the mannequin parts.
Year 0 | Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | |
Cash Flows | $ -12,000.00 | $ 3,200.00 | $ 2,800.00 | $ 2,800.00 | $ 2,200.00 | $ 2,200.00 |
IRR | 3.5% |
The internal rate of return for both the projects are lower than the cost of capital, therefore neither project should be accepted. However, if there is any requirement to accept at least one project, investment is moulding machines may be considered as it has higher internal rate of return.
Decision Making:There are certain rules of decision making pertaining to payback period, net present value and internal rate of return.
Metric | Decision Making criteria |
Payback period | Lower the payback period better the project is |
Net Present Value | For accepting any project, net present value should be positive. Higher the net present value better the project is |
Internal rate of return | For accepting any project, internal rate of return should be higher than the cost of capital. Higher the internal rate of return better the project is |
In this case, neither project seems attractive therefore should not be accepted. In both cases i.e. either projects are independent of each other or projects are mutually exclusive, projects are not adding value for the firm. A summary of different capital budgeting techniques used is shown below:
Metric | Packaging Machine | Moulding Machine |
Payback period | 5 + Years | 4 years 5 months and 14 days |
Net Present Value | $ -4,178.24 | $ -2,907.50 |
Internal rate of return | -0.9% | 3.5% |
Reference:
Berk, Johnathan; DeMarzo, Peter; Stangeland, David (2015). Corporate Finance (3rd Canadian ed.). Toronto: Pearson Canada. p. 64. ISBN 978-0133552683.
Magni, C.A. (2010) “Average Internal Rate of Return and investment decisions: a new perspective”. The Engineering Economist, 55(2), 150‒181.
Pogue, M.(2004). Investment Appraisal: A New Approach. Managerial Auditing Journal.Vol.19 No. 4, 2004. pp. 565–570
First Investment | Involves a packaging machine, which can be used to package garments for shipping orders to customers | |||||||||
Capex | $ 14,000.00 | |||||||||
Cost of Capital | 15% | |||||||||
Year 0 | Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | |||||
Cash flows | $ -14,000.00 | $ 4,100.00 | $ 3,300.00 | $ 2,900.00 | $ 2,200.00 | $ 1,200.00 | ||||
Discount Factor | 1.000 | 0.870 | 0.756 | 0.658 | 0.572 | 0.497 | ||||
NPV | $ -4,178.24 | |||||||||
IRR | -0.9% | |||||||||
Payback period | More than 5 years | |||||||||
Second investment | Molding machine that would be used to mold the mannequin parts. | |||||||||
Capex | $ 12,000.00 | |||||||||
Cost of Capital | 15% | |||||||||
Year 0 | Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | |||||
Cash Flows | $ -12,000.00 | $ 3,200.00 | $ 2,800.00 | $ 2,800.00 | $ 2,200.00 | $ 2,200.00 | ||||
Discount factor | 1.000 | 0.870 | 0.756 | 0.658 | 0.572 | 0.497 | ||||
NPV | $ -2,907.50 | |||||||||
IRR | 3.5% | |||||||||
Payback period | 4 years 5 months 14 days | 5.455 | 13.65 |