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    CU Boxes Inc. - NPV, IRR, and Payback

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    CU Boxes Inc. makes boxes for shoe manufacturers. One of the machines that CU uses may need replacement. The following information is available to you:
    Revenues will not change if the machine is replaced.
    Both the present machine and the new machine will last 5 years and will have no disposal value in five years.
    The new machine will cost $2,000,000. The old machine can be disposed of right now for a disposal value of $60,000.
    The new machine will reduce operating costs by $600,000 per year (assume cash flows at the end of the years.)

    Assume a required rate of return or discount rate of 9%

    Part 1: Determine if the new machine should be purchased. Use NPV, IRR, and Payback in your analysis where appropriate.
    Part 2: What method (NPV or others) is the best method to use for capital budgeting purposes? Defend your arguments carefully, and take into account the following among other concerns:
    a) Ease of use
    b) Quality of information from such method
    c) Quantity of information from such method

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    Solution Preview

    The investment decisions of a firm are generally known as the capital budgeting, or capital expenditure decisions. The firm's investment decisions would generally include expansion, acquisition, modernization and replacement of the long-term assets. Sale of a division or business (divestment) is also as an investment decision.
    Decisions like the change in the methods of sales distribution, or an advertisement campaign or research and development programs have long-term implications for the firm's expenditures and benefits, and therefore, they should also be evaluated as investment decisions. Several different procedures are available to analyze potential business investments. Some concepts are better than others when it comes to reliability but all provide enough information to get the general scope of the investment.
    NPV is defined as the difference between an investment's market value and its cost. It is only a good investment if it makes money for the company so a positive NPV will be needed. Following steps have to be followed:
    ? Cash flows of the investment project should be forecasted based on realistic assumptions.
    ? Appropriate discount rate should be identified to discount the forecasted cash flows. The appropriate discount rate is the project's opportunity cost of capital.
    ? Present value of cash flows should be calculated using the opportunity cost of capital as the discount rate.
    Net present value should be found out by subtracting present value of cash outflows from present value of cash inflows. The project should be accepted if NPV is positive (i.e., NPV > ...

    Solution Summary

    Response is about 400 words plus four references.