Abel Athletics is considering purchasing new manufacturing equipment that costs $1,300,000 and is expected to improve cash flows by $500,000 in year 1, $350,000 in year 2, $475,000 in year 3, $450,000 in year 4, and $300,000 in year 5.
Key financial metrics for this capital budgeting project have been calculated and provided by the Finance department (see below). A 14% rate of return and a payback period of less than five years are required for the project. These key metrics must include (1) payback period, (2) net present value, and (3) internal rate of return. (Use 6% as the weighted average cost of capital).
In a memo to the CFO, discuss the metrics and make a recommendation whether to accept or reject the project.
Objective: Use effective communication techniques.
Calculate the payback period, net present value, internal rate of return, and modified rate of return for a proposed capital budgeting project.
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. Characteristics of Capital budgeting project:
The exchange of current funds for future benefits.
The funds are invested in long-term assets.
The future benefits will occur to the firm over a series of years.
It should maximize the shareholders' wealth.
It should consider all cash flows to determine the true profitability of the project.
It should provide for an objective and unambiguous way of separating good projects from bad projects.
It should help ranking of projects according to their true profitability.
It should recognize the fact that bigger cash flows are preferable to smaller ones and early cash flows are preferable to later ones.
It should help to choose among mutually exclusive projects that project which maximises the shareholders' wealth.
It should be a criterion which is applicable to any conceivable investment project independent of others.
The five procedures that provide useful information are the Net present Value (NPV), the Payback Rule, MIRR, the Internal Rate of Return (IRR), and the PI).
Under the Payback Method, we compute the amount of time required for an investment to generate cash inflows sufficient to recover its initial cost. Based on this method, an investment is acceptable if its calculated payback period is less than some prespecified number of years. This method is perhaps the easiest to use, but it suffers some important shortcomings: (1) The payback period is calculated ...
This provides the steps to calculate the metrics and make a recommendation whether to accept or reject the project