Capital Expenditure Appraisal
The Main Financial Metrics computed for the project at hand are the Payback Period, Net Present Value and Internal Rate of Return. The necessary computations are outlined in Appendix A of this Memo. In the forthcoming sub-sections a discussion of such techniques will take place. 1. 1 Payback Period This method basically examines the time necessary to recoup the capital expenditure incurred in the envisaged project. Such method is simple to calculate and easy to understand.
In addition, its emphasis on the time take to recover the capital expenditure spent favors cash flow for the company by prioritizing the projects the provide the fastest cash inflows for the organization. The main weakness of this technique is its omission of the time value of money principle. Over time, money loses its value leading to the important assertion that $1 today is much more worth than $1 next year. Such premise stems from the following factors that lead to the aforesaid diminish in the monetary value: • Inflation leads to a loss in value for money.
• Opportunity cost arising from investing money in the project. Therefore by failing to discount future cash inflows the payback method is not portraying accurately the cash flows of the project. Its focus on time taken to recoup the capital expenditure may also fail to highlight the project/s that lead to the maximum enhancement of wealth. This is a serious demerit, since it contradicts with the main aim of financial management, which encompasses maximization of investors’ wealth. The forthcoming methods, namely the Net Present Value technique, try to mitigate the weaknesses identified for this model.
1. 2 Net Present Value/Internal Rate of Return Methods This model abides with the time value of money concept and also focuses on cash flows. After discounting future cash flows the net present value scheme outlines the overall present value that the project will provide to the firm. The Internal Rate of Return is computed by finding via trial and error the discount rate that provides a zero Net Present Value. Such method can be regarded as the determination of the break-even point of the capital project.
When capital projects appraised are not mutually exclusive and can be evaluated independently during their appraisal, the net present value method and the internal rate of return approach will lead towards the same decision stemming from identical results. Yet, the net present value model properly acknowledges the scale of the project, because it is an absolute measure of the project’s financial return. While, the internal rate of return technique utilizes a relative measure to the project’s size and cash flow timing in relation to initial capital costs.
Therefore in case of mutually exclusive projects, which necessitate ranking, these two methods may provide different results. The net present value method outlines financial information of greater quality in these circumstances because it highlights the capital project that provides the highest increase in financial wealth for the firm. Further more, the ranking exercise is much easier to put in practice when the net present value system is used with respect to mutually exclusive projects. In addition, the internal rate of return method can provide erroneous financial information when the cash flows of the project are non-conventional.
In such instances a nil or a vast number of internal rates of return are determined, which would confuse the management accountant and lead the application of such scheme useless. The net present value system does not face such issue. In view of the above-mentioned elements, the net present value method is considered as the best model that an enterprise can adopt in order to appraise capital projects. 1. 3 Final Thought – Viability of Project The capital project is financially viable on all three metrics computed. The payback period is 2 years 346 days, which is lower than 5 years as requested.
A positive net present value of $462,500 is envisaged to be generated, which will lead to an increase in financial wealth. The internal rate of return is 18. 97%, which is also higher than the minimum required rate of return of 14%. Therefore the project is financially viable and should be undertaken in light of such figures. At this stage it is also pertinent to outline that qualitative features should also be considered because they too affect the worthiness of a project and management should refrain from focusing solely on financial figures.
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