Capital Investment Appraisal

The article discusses Capital Investment Appraisal, Evaluation of two alternative options of capital investments, Calculation of Weighted Average Cost of Capital (WACC), Evaluation of a Replacement Decision and more. It includes calculations and workings to evaluate the options and make a decision. The subject is finance and the course code is not mentioned. The college/university is not mentioned.

Running Head: Capital Investment Appraisal
Capital Budgeting Decisions

Capital Investment Appraisal 1
Question 1: Evaluation of two alternative options of capital investments
In the present case of NCC Group Ltd., the capital budgeting decision in regards to the
acquisition of machinery is being considered. The firm has two alternative options available and
one is to be chosen on the basis of the cost benefit analysis. One option is to acquire Machine A.
The acquisition of Machine A will require an initial investment of £80,000. The economic life of
Machine A is 4 years and during its life span it will entail a net cash inflow after taxation of
£32,000 each year. The residual value of the machine will be Nil. The other option that is
available to the firm is to acquire Machine B which will cost £75,000 and will have the same
useful life as that of Machine A. However, the cash flows after tax that the Machine B will
generate will be £30,000 per year. The scrap value of this machine will also be Nil at the end of
its economic life.
To evaluate the investment in the proposed alternative options, key techniques of capital
budgeting will be used such as Net Present Value Analysis, Payback Period Analysis and the
Profitability Index.
Part a): Payback Period:
The technique of payback period will be applied before relying on the results of NPV method.
Payback period is the length of time which the project will require to cover up its cost of
investments (Drake, n.d.). It is an important criterion to decide whether the project is acceptable
or not. Generally, the project with lower payback period is accepted as it indicates that the firm
be able to recoup its initial cost in less time as compared to the project that has higher payback
period. The calculation of payback period of both the machines is shown as below:
Machine A

Capital Investment Appraisal 2
Pay-back period Initial Investment £ 80,000.00 2.50 Years
Annual cash inflows £ 32,000.00
Machine B
Pay- back period Initial Investment £ 75,000.00 2.50 Years
Annual cash inflows £ 30,000.00
Decision: In the present case, the payback period of both the machines is calculated as equal and
therefore, it will be indifferent to choose any machine over other.
Part b) Net Present Value:
The net present value of the project is the sum total of present value of all the cash flows
associated with the project (Ryan & Ryan, 2002). Under this technique, the cost of capital is to
taken into consideration to determine the present values of all the possible cash flows linked to
the project. In case of evaluation of two or more options the project that has higher NPV is
favourable to be selected as it will generate more returns for the stakeholders of the project as
compared with the option that will generate low NPV. The calculation of NPV of both the
machines under consideration, in the case of NCC group is shown below:
Machine A
Years 0 1 2 3 4
Initial Investment
-£
80,000.00

Capital Investment Appraisal 3
CFAT
£
32,000.00
£
32,000.00
£
32,000.00
£
32,000.00
PVAF @ 12% 1 0.893 0.797 0.712 0.636
PV of CFAT
-£
80,000.00
£
28,571.43
£
25,510.20
£
22,776.97
£
20,336.58
NPV
£
17,195.18
Machine B
Years 0 1 2 3 4
Initial Investment
-£
75,000.00
CFAT
£
30,000.00
£
30,000.00
£
30,000.00
£
30,000.00
PVAF @ 12% 1 0.893 0.797 0.712 0.636
PV of CFAT
-£
75,000.00
£
26,785.71
£
23,915.82
£
21,353.41
£
19,065.54
NPV
£
16,120.48

Capital Investment Appraisal 4
Decision:
In the instant case, NPV of both the machines is positive and hence both seem to be profitable.
However, the NPV of Machine A is more than that of Machine B. Therefore, from the NPV
perspective, Machine A is more profitable to be acquired than the Machine B.
Part c) Profitability Index:
The profitability index is an important measure to rank the different possible options of capital
investment. The project that has profitability index of value greater than 1 is acceptable as it
shows the present value of all the future cash flows the project is greater than the initial cost of
the project. When comparing two or more alternative capital investment options, the option that
has higher profitability index must be ranked above the projects that have lower PI. Ultimately,
that project must be selected which has highest PI. The calculation of profitability index of both
the machines is shown below:
Profitability Index= NPV+ Initial Investment
Initial Investment
(Peterson & Fabozzi, 2002).
Machine A £ 97,195.18
£ 80,000.00
1.21
Machine B £ 91,120.48

Capital Investment Appraisal 5
£ 75,000.00
1.21
Decision:
The profitability index of both the options under consideration is found to be equal and it is not
possible to rank any of the machines above or below the other machine. The PI of 1.21 shows
that investment in both the machines is profitable because of higher present values of future cash
flows of the project than its cost of initial investment (Bennouna, Meredith & Marchant, 2010).
Part d)
The above calculations have shown that both the investment options are equally beneficial from
the point of view of payback period and profitability index. However, since only one machine is
to be selected by NCC group, it be recommended to select Machine A over Machine B as it has
higher Net present value and therefore has the higher return potential. The higher NPV of
Machine A shows that it will be more profitable than Machine B.
Question 2: Calculation of Weighted Average Cost of Capital (WACC)
Using Bond-Yield-plus-Risk-Premium approach
Items
Proport
ion Calculation Rates
Weighted
Rates
Debt 50% Working Note: 1 4.03% 2.02%
Common Equity 46% Working Note: 2 9.8% 4.51%

Capital Investment Appraisal 6
Preference Shares 4% Working Note: 3 7.63% 0.31%
Weighted
Average Cost of
Capital (Frank,
& Goyal, 2009. 6.83%
Workings:
1
After Tax cost of
debt=
Before Tax Cost of Debt (1-Tax Rate) (Brigham & Houston,
2012).
6.50 (1-0.38)
=4.03%
2 Cost of Equity As per Bond yield risk premium approach
Kd + Rp (Truong, Partington & Peat, 2008).
Kd= Cost of debt before tax
Rp= Risk Premium
=6.50% + 3.30%
=9.80%
3
Cost of
preference shares
Annual preferred dividend/ Preferred stock net offering price
(Ross, Jaffe & Westerfield, 2008).
$ 1.35/ $ 17.7

Capital Investment Appraisal 7
=7.63%
Therefore, as per bond yield plus risk premium approach, the WACC of Jemz Corporation is
6.83%.
Question 3: Evaluation of a Replacement Decision:
Part a)
Introduction:
In the present case of Huanzoo LLC plc, the replacement decision is being considered by the
firm for the usage of machinery in its business. The firm is proposing to replace its existing
machinery with a new one in order to manufacture the goods more effectively and efficiently so
as to increase the overall profitability of the project. At the current date, the firm has two options
available with it and it has to select one among the two alternatives for the subsequent period of
five years. Replacement decisions are the key decisions under capital budgeting function of
financial management studies. These decisions involves selection of one alternative option over
other because of its potential to generate more returns and low risk involvement in the same.
Under such decisions, the firm has two or more than options to consider. One is the analysis of
continuation of the existing machine, unit or product and the other is to dispose the existing
machine, unit or product and to take up new machine or unit for the further periods.

Capital Investment Appraisal 8
Replacement decision evaluation using capital budgeting technique:
In the present case of Huanzoo LLC plc, the existing machinery in use in the business has
already been acquired few years back and hence its cost of acquisition is irrelevant for the
evaluation purpose. However, the cost of acquisition of new machinery is relevant as it is yet to
be incurred in case of its acceptance. If the option of investment in the new machinery is
accepted then the old machinery will be sold at the start of 1st year and hence the proceeds from
its sale in the market will be adjusted from the cost of acquisition of new machinery.
If the new machinery is implemented in the business, it will result in increased production and
therefore the volume of sales units will also be increased. However, more units of products can
only be sold in the market at the reduced selling price. Therefore, the price of the product dealt
by Huanzoo LLC will be reduced from £10.50 per product to £8.70 per product unit. The new
machinery will increase the overall sales of the business. Also, the production cost per unit of
production will be reduced as a result of acquisition and implementation of new machinery.
Since the production cost does not involve depreciation expense and no tax rate is given in the
case, it will be assumed that the firm is enjoying the benefit of tax exemption. Therefore, no
treatment of depreciation expense on the new machinery will be given. It will also be assumed
that the scrape value of existing machinery will be realised in full i.e. at £35,000.
The individual evaluation of both the options under consideration is undertaken separately rather
than adopting the incremental cash flow approach. The net present value method is used to
identify the worthiness of both the machines. From the calculation it is found that NPV of cash
flows from existing machinery is higher than that of new machinery. This indicates that the firm
must continue its operations with the existing machine and should not acquire the new

Capital Investment Appraisal 9
machinery. Though the investment in new machine will increase the profitability of the business
but the cash flows will decrease due to the incurrence of cost of acquisition of the new
machinery. The calculation of separate NPVs of the machines is shown below:
Existing
Machine
Years 1 2 3 4 5
Sales
£
5,250,00
0.00
£
5,775,00
0.00
£
6,300,00
0.00
£
7,350,00
0.00
£
8,925,00
0.00
Less: Production
£
4,081,00
0.00
£
4,081,00
0.00
£
4,697,00
0.00
£
5,544,00
0.00
£
6,237,00
0.00
Net Profit
£
1,169,00
0.00
£
1,694,00
0.00
£
1,603,00
0.00
£
1,806,00
0.00
£
2,688,00
0.00
Add: Scrap
Value
£
22,000.0
0
Total Cash
Flows
£
1,169,00
0.00
£
1,694,00
0.00
£
1,603,00
0.00
£
1,806,00
0.00
£
2,710,00
0.00
PVAF @ 11% 0.901 0.812 0.731 0.659 0.593
Present Value of £ £ £ £ £

Capital Investment Appraisal 10
Cash Flows
1,053,15
3.15
1,374,88
8.40
1,172,09
9.78
1,189,66
8.14
1,608,25
3.10
NPV
£
6,398,06
2.58
New Machine
Years 0 1 2 3 4 5
Initial
Investment
-£
1,215,000.00
Sales
£
5,655,00
0.00
£
6,264,00
0.00
£
6,960,00
0.00
£
8,091,00
0.00
£
9,135,00
0.00
Less: Production
£
4,284,00
0.00
£
4,473,00
0.00
£
5,229,00
0.00
£
5,859,00
0.00
£
6,300,00
0.00
Net Profit
£
1,371,00
0.00
£
1,791,00
0.00
£
1,731,00
0.00
£
2,232,00
0.00
£
2,835,00
0.00
Add: Scrap
Value
£
170,000.
00
Total Cash
Flows
£
1,371,00
£
1,791,00
£
1,731,00
£
2,232,00
£
3,005,00

Capital Investment Appraisal 11
0.00 0.00 0.00 0.00 0.00
PVAF @ 11% 0.901 0.812 0.731 0.659 0.593
Present Value of
Cash Flows
-£
1,215,000.00
£
1,235,13
5.14
£
1,453,61
5.78
£
1,265,69
2.28
£
1,470,28
7.53
£
1,783,32
1.24
NPV
£
5,993,051.97
Conclusion:
From the above analysis, it can be concluded that Huanzoo LLC must not accept the proposed
investment option as it will not enhance its overall cash flows. Rather, the firm must continue its
manufacturing with the old machinery as it will offer higher returns to the stakeholders of the
business since no further investment is required in its acquisition or modification.
Part b)
Further matters that the directors of Huanzoo LLC must take into account before deciding about
the replacement decision are as follows:
 The directors must also consider the payback period of the both the investment options to
determine the length of time each machine will take to recover its cost of investment.
 The firm must also consider the internal rate of return and accounting rate of return of
both the projects before taking the ultimate decision as these rates suggests the return
potential of the projects.

Capital Investment Appraisal 12
 While deciding on the matter of continuing the business operations with the existing
business, the directors must consider the requirement to revise the useful life or terminal
value of the existing machine due to change in the economic or other conditions.
 Further, the directors must consider their basic operation of the business. If the basic
objective of Huanzoo LLC is wealth maximisation, then it must opt for the existing
machinery as it entails higher positive cash flows than the new machinery and if the firm
has the basic objective of profit maximisation it must consider adopting the new machine
as the same will offer it higher profitability (Baker, Jabbouri & Dyaz, 2017).
Question 4:
The present case deals with the importance of cash flows for the business even when the business
is earning or expected to earn significant quantum of profits. Jay trader has improved its quantum
of sales by allowing free credits to its regular customers for a term of 6 months after the
recession period to allow its sales to grow constantly. However, the business that was run by Jay
Traders involved importation of cars at the commencement of each quarter and the payment for
the same was to be made at the closure of such quarter. The suppliers of cars did not offer any
further credit period for the purchases of cars by Jay Traders. This certainly has affected the cash
operating cycle of the firm and made it experience the liquidity and solvency concern in the
market.
Yes it is correct to say that Jay Traders is facing the trouble in maintaining a sound position of
liquidity in the market. Though the projections made by the financial manager of Jay Traders for
the coming years for the business are reflecting the sound profitability position of the business
because of constant growth in the sales due to the fact that the firm is readily available to allow

Capital Investment Appraisal 13
free trade credits to its customers for 6 months which is quite a longer term. Though the
allowance of trade credits has improved the profitability of the business as a result of increased
sales, it is adversely affecting the cash management system of the business and due to this the
business has to face the liquidity concerns in the market (Knight, 2012). The cash crunch might
not allow the business to pay off its existing interest and debt obligations to the providers of
finance such as bank and other financial institutions (Almeida, Campello & Weisbach, 2004).
Hence, the banks might have raised concern about the solvency position of the firm and
consequently they had to refuse to fulfil its further credit requirements (Hanlon, 2005). If banks
or other financial institutions do not allow Jay Traders a further credit, the firm will have to face
difficulty in making payments for its purchases of raw materials and its operating expenses of
business. This will ultimately lend the business in the insolvency position (Higgins, 2012).
Yes, the bank is correct to withhold the provision of further credit to Jay Traders looking at its
liquidity and solvency position. Though the income statements of the firms might be reflecting
sound profitability position but the cash flow statement and statement of final position of the
business more clearly indicates the true position of cash, trade receivables and payables and the
debt obligations of the business (Brahmasrene, Strupeck & Whitten, 2004). The financial
statements serve the prime documents on the basis of which the banks and other financial
institutions provide finance to the required parties and therefore it is of utmost importance of
such providers of finance to assess the projections of financial position of business and also the
trends followed by the business in achieving its financial results (Beck, Levine & Loayza, 2000).
To assess the financial position of business, consideration of merely profitability situation of
business is not sufficient. Rather, it becomes equally necessary for the banks to take into account
the liquidity and solvency position of the business (Foster, 2004). When the financial projections

Capital Investment Appraisal 14
are clearly indicating the rising level of profits of the business along with the increase of trade
receivables and declining level of cash balances of business, the banks are totally correct in
withholding the credit provisions to such businesses (Fernandez, 2001).
The major reason behind the increasing indebtedness of the business is the allowance of longer
trade credits to the customers and that too in the free terms without charging any interest on such
trade credit allowances. Though these trade credit policies are contributing positively to the
profits of the business but it is severely affecting the cash position of the business as the firm has
to face cash crisis while paying off for its purchases and other operating expenses. The low cash
maintenance of the business is not only impeding its liquidity position but also increasing the
financial risk on the company that the company may have to the situation of insolvency in the
market due to such excessive trade credit provisions (Ferreira & Vilela, 2004). Since the firm is
facing shortage of funds to meet its long term debt obligations, its indebtedness is quickly
increasing (Van Horne James, 2002).
Conclusion:
From the analysis of the above case of Jay Traders, it can easily be concluded that though profits
are the integral part of sound performance of the business but at the same time cash flows of the
business also impacts its sound functioning to a great extent. A firm that looks attractive from the
profits point of view may not necessarily be attractive from the cash point of view because sales
of the business can be increased by the introducing of various trade credit policies in it but it
would not increase the cash inflow for the business. Rather this trade credit allowance amounts
to excessive blockage of the funds of the business in purchase of raw materials and in meeting
the operating expenses of the business. Therefore, the sound profitability position of the business

Capital Investment Appraisal 15
never allows the managers to judge its liquidity and solvency position. Hence, to operate the
business effectively and efficiently, Jay Traders must shorten the length of its trade credit periods
provided to its customers in order to make proper balance between the profitability and solvency
position of the business. Further, Jay Traders must introduce such trade credit policies that
involve charging of interest for the provision of such credits so as to set off the cost of blockage
of its funds.

Capital Investment Appraisal 16
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Capital Investment Appraisal 17
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Capital Investment Appraisal 18
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