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Finance: Appraisal of Capital Investment Decisions

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Added on  2020-04-21

Finance: Appraisal of Capital Investment Decisions

   Added on 2020-04-21

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Finance: Appraisal of Capital Investment Decisions1
Finance: Appraisal of Capital Investment Decisions_1
IntroductionThe capital investment decisions involve huge sum of money therefore it is of paramountimportance for the management to make these decisions after carrying out the analysiseffectively. There are various tools and techniques being applied for the purpose of analyzing thefinancial viability of a capital investment, the most prominent among them is the net presentvalue technique (NPV) (Atrill and McLaney, 2008). The other techniques involve internal rate ofreturn (IRR), payback period, and accounting rate of return. In this context, the report presentedhere provides discussion on various techniques of capital investment analysis such as NPV, IRR,Payback period etc. Further, the report also demonstrates the practical application of NPVtechnique in analyzing the machine replacement decision (Atrill and McLaney, 2008).Part-1Watley’s is considering replacing the old machine with the automated new machinewhich is expected to reduce the manufacturing cost to a large extent over the period of fouryears. The machine will initially cost £60,000 and require a sum of £2,000 being incurred peryear on maintenance. The new machine is expected to reduce the manufacturing labor cost by£22,000 for four years. In order to analyze that whether this replacement decision would befinancially worthwhile or not, the NPV has been computed as below:NPV of ProjectYearCash FlowsPVF@10%PV0 (60,000.00) 1.000 (60,000.00)1 20,000.00 0.909 18,181.82 2 20,000.00 0.826 16,528.93 3 20,000.00 0.751 15,026.30 4 20,000.00 0.683 13,660.27 NPV 3,397.31 2
Finance: Appraisal of Capital Investment Decisions_2
It can be observed from the computations shown in the table given above that the NPV ofreplacement is £3,397.31. The positive NPV of replacement decision reflects that it would beworthwhile to implement the replacement of the machine. Thus, it is advised that the companyshould go for replacement of old machine with the new automated machine.Part-2There are three crucial elements found in any capital investment decisions such as cashinflows, outflows, and discount rate. In order to compute cash inflows, outflows, and discountrate, there are made a number of assumptions. The capital investment decision is futuristic andthus, assumptions are made about the future outlook in respect of these three crucial elements(Röhrich, 2014). The computation of cash inflows requires estimation about the sale units andunit price. Similarly, estimations are made in respect of costs to arrive at the cash outflows.Further, the determination of discount rate requires various assumptions about the risk andexpected return of the investors (Röhrich, 2014).The discounting of cash flows is normally done at the desired rate of return of theinvestors which in the case of a company is taken as WACC. Further, the computation of WACCis based on the estimations of cost of equity and after tax cost of debt. The estimation of cost ofdebt is however simple and requires less assumptions but the same is not the case with cost ofequity. The cost of equity is computed based on various assumptions, for example, assumptionabout future dividend payment, growth rate, risk free rate, and market risk premium. Further, theassumptions are also required to be made about the life span of the project in which capitalinvestment is being made (Röhrich, 2014).3
Finance: Appraisal of Capital Investment Decisions_3

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