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Capital Expenditure Appraisal Essay

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Part 1

1.1  Capital Expenditure Appraisal

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The capital expenditure decision of purchasing a more efficient machine by CU Boxes Incorporation shall be evaluated with the aid of the three main methods of capital expenditure.  The determination of the project feasibility under all methods is shown in the sub-sections below.

1.1.1 Pay Back Method

Description
$’000
Capital Expenditure
(2,000)
Cash Inflow (Year 1) {600 + 60)
660
Outstanding Balance
(1,340)
Cash Inflow (Year 2 & 3) {600 + 600)
1,200
Outstanding Balance
(140)
Cash Inflow Year 4
1,200

1,060

Source: Randall H. 1996, p 442 and 443.

1.1.2 Net Present Value Method

Description
0

$’000
1

$’000
2

$’000
3

$’000
4

$’000
5

$’000
Cash Inflow/(Outflow)
(1,940)
600
600
600
600
600
9% Discount Factor
1
0.91743
0.84168
0.77218
0.70843
0.64993
Present Value
(1,940)
550.46
505.01
463.31
425.06
389.96

Net Present Value: $393.80

Source: Brockington B. R. 1993, p 107 and 108.

1.1.3 Internal Rate of Return Method

Year
Net Cash

Inflow/(Outflow)
Disc. Factor 16%
Disc. Factor

17%
Present Value at

16%
Present Value at

17%
0
(1,940)
1.0
1.0
(1,940)
(1,940)
1
600
0.86207
0.85470
517.24
512.82
2
600
0.74316
0.73051
445.90
438.31
3
600
0.64066
0.62437
384.40
374.62
4
600
0.55229
0.53365
331.37
320.19
5
600
0.47611
0.45611
285.67
273.67

24.58
(20.39)

Source: Randall H. 1996, p 446 and 447.

1.1.4 Feasibility Analysis of Capital Project

All the capital expenditure appraisal techniques adopted favor the installment of the new machine in CU Boxes Incorporation.  The payback method, for instance reveals that the organization will take 3 years 3 months to recoup the original investment made in the capital project.

  Such method always promotes the acceptance of projects with the shortest payback period (Lucey T. 2003, p 411).  In this case data for the computation of only one project were available.  Therefore we cannot compare the payback of this project with other similar projects.  In this respect, the adoption decision of the new machine is automatically favorable because the original cost will be recouped by the cash inflows derived from lower operating costs, which are improved from the greater efficiency of the aforesaid machine.

The methods, which utilize the time value of money principle, also portray the feasibility of the project.  The net present value approach shows that a net present value of $393,800 will be achieved by the purchase and adoption of the new machine.  A positive net present value implies that a potential increase in monetary wealth will be attained by the project. Such future cash inflows relevant to the project appraised are valued in present day terms under the net present value system, through the adoption of an appropriate discount rate set by the organization in accordance with a number of business and economic factors (Drury C. 1996, p 389 and 391).  The higher the net present value the more financially worth the project for the corporation.  As already stated, due to lack of information, this project cannot be compared with similar solutions that can be applied in CU Boxes Incorporation.

The internal rate of return model is also based on the premise of time value of money.  The figure of 16.71% derived from the computation of the internal rate of return for the case provided means that at that discount rate the net present value of the capital project appraised will be zero.  This implies that if the discount rate exceeds 16.71%, a negative net present value will be derived from the project at hand leading to its financial unfeasibility.  The higher the internal rate of return the more desirable is the capital project in view of a higher margin of safety for positive net cash flows (Lucey T. 2003, p 416 and 417).  We have to keep in mind that today’s dynamic and turbulent business environment increase the need of greater margin of safety in light of unexpected movements, which negatively affect the project evaluated.  In this respect, the purchase of the new machine is also constructive for CU Boxes Incorporation under this method.

Part 2

1.2Most Optimal Capital Expenditure Appraisal Method

The payback method is normally more beneficial than the other two methods because it is simple to calculate and understand (Lucey T. 2003, p 412).  Its focus on cash flow rather than accounting profits also enhances its easy of use because fictitious accounting elements like depreciation are removed from the capital expenditure analysis.  Management usually more inclined towards appraisal methods, which they can easily comprehend due to their straightforwardness.

This capital expenditure appraisal method, however serious lacks with respect to quality and quantity of financial information provided.  It focuses only on the capability of the project to cover the initial capital expenditure incurred.  Neglection of the overall project value for the organization and of the important economic principle of time value of money lead to the aforementioned limitation in the information given (Lucey T. 2003, p 412).  These serious limitations thus hinder the payback method from being the most optimal capital expenditure appraisal method that a company can adopt.

The adoption of discounting, which adheres with the time value of money principle, which takes into account important business and economic factors such as the inflation rate, the risk-free component, general risk premium and property-specific risk premium is considered by the internal rate of return and net present value method (Window on State Government).  Even though they are more complex in nature and require more technical calculations, these two methods provide valuable financial information of a much better quality.

When the capital projects evaluated are not mutually exclusive and can be considered independently during the valuation, the net present value method and the internal rate of return approach will provide identical results, leading to the same decision.  However, the scale of the project is properly considered by the former capital expenditure appraisal model, because it is an absolute measure of the project’s financial return.  On the contrary, the internal rate of return system adopts a relative measure to the project’s size and cash flow timing in relation to initial capital expenditure (Lucey T. 2003, p 418).  Therefore when projects are mutually exclusive and ranking is necessary in the business valuation, these two methods may provide dissimilar results.  The net present value method provides financial information of greater quality in such instances because it directs towards the capital project that holds the highest increase in financial wealth for the organization.  In addition, the ranking exercise is much easier to apply when the net present value method is adopted for mutually exclusive projects (Lucey T. 2003, p 419 and 420).

The internal rate of return model can also provide misleading information when cash flows are non-conventional in the capital project examined.  In such cases, a nil or a vast number of internal rates of return may be derived, which would render the application of such method useless.  This problem does not apply to the net present value method (Lucey T. 2003, p 421).

In view of the above factors, we can state that the net present value method is the best method that an organization can adopt in order to value its capital projects.

References:

Brockington B. R. (1993). Financial Management. Sixth Edition. London: DP Publications.

Drury C. (1996). Management and Cost Accounting. Fourth Edition. New York: International Thomson Business Press.

Lucey T. (2003). Management Accounting. Fifth Edition. Great Britain: Biddles Limited.

Randall H. (1999).  A Level Accounting.  Third Edition.  Great Britain:  Ashford Colour Press Ltd.

Window on State Government. Manual For Discounting Oil and Gas Income (on line).  Available from: http://www.window.state.tx.us/taxinfo/proptax/ogman/ (Accessed 30th May 2007).

 

Cite this Capital Expenditure Appraisal Essay

Capital Expenditure Appraisal Essay. (2016, Dec 09). Retrieved from https://graduateway.com/capital-expenditure-appraisal/

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