Capital Budgeting Analysis for ABC Corporation

This analytical report evaluates two options for ABC Corporation through capital budgeting methods - Net Present Value and Internal Rate of Return. The analysis helps determine whether to purchase a new asset or repair the existing one.

FINANCE

Contents
Introduction...........................................................................................................................................3
Analysis of both options........................................................................................................................3
Net Present Value method...................................................................................................................3
Internal rate of return.........................................................................................................................6
Conclusion.............................................................................................................................................7

Introduction
The analysis brings out an evaluation of two options of ABC Corporation regarding whether
to purchase the asset or repair the old existing asset. The evaluation will be through capital
budgeting method. This analytical report has undertaken two methods NPV (net Present
Value) and internal rate of return. As per the instruction of boss, the NPV has been calculated
on three rates 12%, 14%, and 16%.
Analysis of both options
Capital Budgeting is a process through which a business monitors huge investments such as
purchasing a new plant, machine, and building or investing long-term ventures. Some of the
techniques used for evaluation are Net present value and internal rate of return. NPV is the
difference between present values of cash inflows and present cash outflows in a particular
period. It is used to examine the profitability of the projected project. For the purpose of
evaluation, when the value of revenues is more than costs, then NPV is positive and the
project should be accepted.
Net Present Value method
Option-A: Repair the Machine
Year Cash Flows DCF@12% Present Value
0 $ -50,000.00 1.0 $ -50,000.00
1 $ 15,500.00 0.9 $ 13,839.29
2 $ 20,100.00 0.8 $ 16,023.60
3 $ 18,900.00 0.7 $ 13,452.65
4 $ 17,100.00 0.6 $ 10,867.36
5 $ 13,700.00 0.6 $ 7,773.75
NPV $ 11,956.64

Option-B: Buy a new Machine
Year Cash Flows DCF@12% Present Value
0 $ -4,00,000.00 1.00 $ -4,00,000.00
1 $ 51,300.00 0.89 $ 45,803.57
2 $ 1,55,000.00 0.80 $ 1,23,565.05
3 $ 1,27,800.00 0.71 $ 90,965.52
4 $ 1,26,900.00 0.64 $ 80,647.24
5 $ 1,25,100.00 0.57 $ 70,985.10
NPV $ 11,966.48
From the above tables, it can be seen that after calculating NPV at 12% for both the options.
It can be interpreted that the company should opt the option-B, which is buying a new
machine. Moreover, 12% is the WACC (weighted average cost of capital) of the company
that meaning it is a feasible rate and until 12%, the risk associated with the cost of capital is
moderate.
Option-A: Repair the Machine
Year Cash Flows DCF@14% Present Value
0 $ -50,000.00 1.00 $ -50,000.00
1 $ 15,500.00 0.88 $ 13,596.49
2 $ 20,100.00 0.77 $ 15,466.30
3 $ 18,900.00 0.67 $ 12,756.96
4 $ 17,100.00 0.59 $ 10,124.57
5 $ 13,700.00 0.52 $ 7,115.35
NPV $ 9,059.67

Option-B: Buy a new Machine
Year Cash Flows DCF@14% Present Value
0 $ -4,00,000.00 1.00 $ -4,00,000.00
1 $ 51,300.00 0.88 $ 45,000.00
2 $ 1,55,000.00 0.77 $ 1,19,267.47
3 $ 1,27,800.00 0.67 $ 86,261.36
4 $ 1,26,900.00 0.59 $ 75,134.99
5 $ 1,25,100.00 0.52 $ 64,973.02
NPV $ -9,363.17
From the Above tables, it can be said that at 14% rate, the company should select option-A
which is repairing the machine. Increasing rate of NPV will increase the risks associated with
the selection, which means if the company engage in option-B, it will have to face a huge
risk. At 14% rate, the company should opt to repair the machine. Investing to buy the asset
(choosing the option-B) will lead to negative cash flows.
Option-A: Repair the Machine
Year Cash Flows DCF@16% Present Value
0 $ -50,000.00 1.00 $ -50,000.00
1 $ 15,500.00 0.86 $ 13,362.07
2 $ 20,100.00 0.74 $ 14,937.57
3 $ 18,900.00 0.64 $ 12,108.43
4 $ 17,100.00 0.55 $ 9,444.18
5 $ 13,700.00 0.48 $ 6,522.75
NPV $ 6,375.00

Option-B: Buy a new Machine
Yea
r Cash Flows DCF@16% Present Value
0 $ -4,00,000.00 $ 1.00 $ -4,00,000.00
1 $ 51,300.00 $ 0.86 $ 44,224.14
2 $ 1,55,000.00 $ 0.74 $ 1,15,190.25
3 $ 1,27,800.00 $ 0.64 $ 81,876.05
4 $ 1,26,900.00 $ 0.55 $ 70,085.74
5 $ 1,25,100.00 $ 0.48 $ 59,561.74
NPV $ -29,062.08
Form the above tables, it can be seen that at 16% rate, the company should choose option-A
which is repairing the machine. This 16 percent is the cost of capital, which means the
company will have to bear huge risk. Investing in option-B will take the company into huge
trouble, as the net present value of the asset is negative.
Internal rate of return
Option-A: Repair the Machine
Yea
r Cash Flows
0 $ -50,000.00
1 $ 15,500.00
2 $ 20,100.00
3 $ 18,900.00
4 $ 17,100.00
5 $ 13,700.00
IRR 21.44%

Option-B: Buy a new Machine
Yea
r Cash Flows
0 -£4,00,000.00
1 £51,300.00
2 £1,55,000.00
3 £1,27,800.00
4 £1,26,900.00
5 £1,25,100.00
IRR 5.42%
IRR (internal rate of return) is a metric used as the technique in order to estimate the
profitability of the investments. While evaluating the IRR, it is profitable when WACC is less
than IRR. Form the above tables, it can be seen that the IRR for option-A is more than
WACC and option-B which indicates that it would be feasible for the company to choose
Option-A.
Conclusion
From the above analytical discussion, it can be said if the company thinks of going to higher
rate especially that is above WACC will increase the risk for the company. At 12% rate,
buying a machine is better is the best option. According to IRR, option-A is considered best
as the IRR is greater than WACC of the company. As a manager, I would suggest it would be
better to purchase the asset (option-B) because at WACC, it is most suitable.