Capital Budgeting Decisions

Question: Discuss about theCapital Budgeting Decisions. Answer: Definition of the Problem The purpose of the report is to help the GM (A Large Carpentering Firm) to take the investment decision. GM wants to replace one of its existing sawing machines with the new one. For this purpose, two alternate sawing machines are considered, machine A is fully automated while machine B operates on standard technology. The problem is to find out which machine will be best suitable for replacement through using capital budgeting techniques such as NPV, IRR and pay back period method. Objectives There is clear objective to evaluate proposed Machines (A and B) with the help of various techniques of capital budgeting techniques. Another purpose is to guide management of GM on selection of best alternative through applying practical as well as theoretical aspects of capital budgeting. Methods Used In order to evaluate the Machine A and Machine B through using capital budgeting methods, following methods have been used. Pay Back Period Method Pay back period method is one of the most used methods used for capital budgeting decisions. It measures the length of time required to recollect the expenses made on the project in first year. It helps to analyst to know whether to undertake the project or not. Longer pay back periods are not desirable for investment purpose as compare to project where cost of project is recovered in less time (Brigham and Ehrhardt, 2011). This method does not consider time value of money and cash inflows are subject to any present value factor as in case of other methods. In case GM firm, Mr. David wants to evaluate two machines on pay back period basis. Calculations are as under: Machine A Machine B Years Cash Inflows Cumulative Cash Inflows Cash Inflows Cumulative Cash Inflows 1 128000 128000 88000 88000 2 182000 310000 120000 208000 3 166000 476000 96000 304000 4 168000 644000 86000 390000 5 450000 1094000 207000 597000 Cost of Machine A: $660,000 Cost of Machine B: $360,000 Pay Back Period of Machine A: 4 years + [(660,000-644,000)/ (1,094,000-644,000)] years = 4 years +0.053 years = 4.053 years Pay Back period of Machine B: 3 years + [(360000-304000/ (390000-304000)] years = 3.65 years Net Present Value Net present value is the difference of present value of cash inflow and present value of cash outflows. This method is used in capital budgeting decisions and helps in evaluating the profitability of project or investment. This method considers time value of money, so, it is regarded as one of best method to evaluate the project for capital budgeting purpose (Pratt, 2010). Machine A Years Cash Inflows Present Value Factor @ 13% Present Value @13% 1 $ 128,000.00 0.885 $ 113,274.34 2 $ 182,000.00 0.783 $ 142,532.70 3 $ 166,000.00 0.693 $ 115,046.33 4 $ 168,000.00 0.613 $ 103,037.55 5 $ 450,000.00 0.543 $ 244,241.97 Total $ 718,132.88 Machine B Years Cash Inflows Present Value Factor @ 13% Present Value @13% 1 $ 88,000.00 0.885 $ 77,876.11 2 $ 120,000.00 0.783 $ 93,977.60 3 $ 96,000.00 0.693 $ 66,532.82 4 $ 86,000.00 0.613 $ 52,745.41 5 $ 207,000.00 0.543 $ 112,351.31 Total $ 403,483.24 Net Present Value of Machine A: Present value of cash inflows for Machine A Present values of cash outflows for Machine A = $ 718,132.88 - $ 660,000 = $ 58132.88 Net Present Value of Machine B: Present value of cash inflows for Machine B Present values of cash outflows for Machine B = $ 403,483.24 - $ 360,000 = $ 43483.24 Internal Rate of Return Internal rate of return refers to an interest rate where all the present value of cash inflows and cash outflows become zero. This interest rate is the rate at which project will earn if that project is selected (Drake and Fabozzi, 2012). This method of capital budgeting is used to analyze the attractiveness of the project. Project or investment is selected in case IRR is more than the firm required rate of return. Project or investment is rejected where IRR is less than the firm required rate of return. In the case of GM Company, the required rate of return is 13 %. On analyses if it has been found that IRR of Machine A or B is greater than that machine will be selected which has highest IRR (Fridson and Alvarez, 2011). IRR of Machine A: 15.95% IRR of Machine B: 17.34% Key Findings On the basis of above analysis, the key findings are as under: Method Machine A Machine B Pay Back Period 4.053 years 3.65 years Net present Value $ 58,132.88 $ 43,883.24 Internal rate of return 15.95% 17.34% Pay Back Period: As per this method such machine must be selected that has low pay back period. In this case Machine B has low pay back period therefore using rank method, rank 1 is given to machine B and rank 2 is given to machine A (Menicucci, 2014). Net present value method: This method considers time value of money and project having highest NPV will be selected for investment purpose. In the case GM Firm, Machine A provides NPV of $ 58,132.88 while Machine B provides NPV of $ 43,883.24. So, Machine A provides higher NPV as compared to Machine B. On the basis of ranking, Machine (A) ranks 1 and Machine (B) ranks 2. Internal of rate of return: According to this method, project must be selected if it has higher IRR as compared to firm required rate of return. In the case of GM, when IRR of both machines are considered than it has been found that both are greater than firm required rate of return. So, machine that has higher IRR among both will be given rank 1 and other one will rank 2. Conclusions Rankings of Machines as per the method Method Machine A Machine B Pay Back Period Rank 2 Rank 1 Net present Value Rank 1 Rank 2 Internal rate of return Rank 2 Rank 1 On the basis of various factors and ranking procedure applied to choose either machine A and B, it is concluded that GM firm must invest in Machine B to receive the outflows in less time period with highest IRR. As regards to NPV, Machine A has to be selected but it is also true that both machines have positive NPV (Staubus, 2013). Recommendations It is recommended to GM Firm to invest in Machine B due to higher IRR and low pay back period. While making decision of investment, company must be considered other factors of decision like technology, indirect cost and relevance of machine in future. Others Factors that Firm must Consider There are many other factors that firm must considered while taking the investment decisions. Every investment requires outflow of cash at the beginning keeping in mind that such investment will provide higher benefits in future years (Bull, 2007). Therefore, decision related to plant and machine must be evaluated using capital budgeting methods but it is also important to consider factors like technology used in machine, other cost related with machine and functional capacity of the machine. In case of GM firm, Mr. David should consider following factors: Technology: According to technology firm must select Machine A, because it is fully automatic and take less time for manufacturing products as compare to Machine B. Other cost: There are certain costs that are not considered while making analysis through capital budgeting methods. Such cost can be overhead cost like repairing cost of machine, expenses for operator required for fully automatic machine etc (Mumba, 2013). References Brigham, E. F. and Ehrhardt, M. C. 2011. Financial Management: Theory and Practice. 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