Barne plc is considering production and sale of a new type of coffee machine. This will allow them to expand production over the next 7 years and support the drive to sell more of their successful range of products for domestic use. There are two investment options, C4 and C5, for coffee machine and information about the initial investment and four different capital investment appraisal measures are given in the table below. The cost of capital is estimated at 8%. The board of directors of Barne plc is about to attend a meeting to consider which option to choose. The IRR measure was added after the original board papers were released. When asked to estimate the IRR before calculating it, the company's Finance Director confidently stated that it would be "well over 8% for both options." Table1: initial investment option and appraisal methods Investment option Initial investment Accounting rate of return Payback period NPV @8% IRR@10% 10.9% £1200000 13% 2.67 years £1200700 10.9% £1600000 15% 3.17 years £145400 9.5% Critically discuss the usefulness of the FOUR capital investment appraisal measures in the table above. Make a recommendation, with reasons, as to which option should be chosen. Explain why the finance director was so confident that IRR would be well in excess of 8%for both options
Net Present Value
Net present value is the most important concept of finance. It is used to evaluate the investment and financing decisions that involve cash flows occurring over multiple periods. The difference between the present value of cash inflow and cash outflow is termed as net present value (NPV). It is used for capital budgeting and investment planning. It is also used to compare similar investment alternatives.
Investment Decision
The term investment refers to allocating money with the intention of getting positive returns in the future period. For example, an asset would be acquired with the motive of generating income by selling the asset when there is a price increase.
Factors That Complicate Capital Investment Analysis
Capital investment analysis is a way of the budgeting process that companies and the government use to evaluate the profitability of the investment that has been done for the long term. This can include the evaluation of fixed assets such as machinery, equipment, etc.
Capital Budgeting
Capital budgeting is a decision-making process whereby long-term investments is evaluated and selected based on whether such investment is worth pursuing in future or not. It plays an important role in financial decision-making as it impacts the profitability of the business in the long term. The benefits of capital budgeting may be in the form of increased revenue or reduction in cost. The capital budgeting decisions include replacing or rebuilding of the fixed assets, addition of an asset. These long-term investment decisions involve a large number of funds and are irreversible because the market for the second-hand asset may be difficult to find and will have an effect over long-time spam. A right decision can yield favorable returns on the other hand a wrong decision may have an effect on the sustainability of the firm. Capital budgeting helps businesses to understand risks that are involved in undertaking capital investment. It also enables them to choose the option which generates the best return by applying the various capital budgeting techniques.
Barne plc is considering production and sale of a new type of coffee machine. This will allow them to expand production over the next 7 years and support the drive to sell more of their successful range of products for domestic use. There are two investment options, C4 and C5, for coffee machine and information about the initial investment and four different capital investment appraisal measures are given in the table below. The cost of capital is estimated at 8%. The board of directors of Barne plc is about to attend a meeting to consider which option to choose. The IRR measure was added after the original board papers were released. When asked to estimate the IRR before calculating it, the company's Finance Director confidently stated that it would be "well over 8% for both options."
Table1: initial investment option and appraisal methods
|
Investment option |
Initial investment |
Accounting |
Payback period |
NPV @8% |
IRR@10% |
|
10.9% |
£1200000 |
13% |
2.67 years |
£1200700 |
10.9% |
|
|
£1600000 |
15% |
3.17 years |
£145400 |
9.5% |
- Critically discuss the usefulness of the FOUR capital investment appraisal measures in the table above.
- Make a recommendation, with reasons, as to which option should be chosen.
- Explain why the finance director was so confident that IRR would be well in excess of 8%for both options.
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