Operation Kalahari Desert Ltd is considering investing in a new machine in order to reduce operations costs over the next five years. Machine X and Y are currently being considered, the details of which are as follows: X Y Capital cost N$300,000 N$350,000 Residual value N$50,000 N$70,000 Annual cost savings N$30,000 N$56,000 The above cost savings have been calculated after the deduction of depreciation on a straight- line basis over the life of the investment. Because of liquidity considerations, the managing director states that the project should have a payback period of less than four years. The company’s cost of capital is 10%, the discounts factors for which are: Year 1 0.909 Year 2 0.826 Year 3 0.751 Year 4 0.683 Year 5 0.621 Required: a. Evaluate each of the machines X and Y, using the following methods: i. Accounting rate of return using the average capital invested(using profits not cash flows) ii. Payback period(using cash flows not profits) iii. Net Present Value (16) b. Advise management, giving reasons, as to which machine to purchase. (4) c. Calculate for each machine, a discounted payback period (using discounted cash receipts), and state whether this would have any effect on your answer to (b) above.
In the dynamic landscape of business operations, prudent investment decisions play a pivotal role in determining the long-term success and competitiveness of an organization. Operation Kalahari Desert Ltd is currently faced with a strategic choice between two machines, Machine X and Machine Y, which aim to streamline operations and reduce costs over the next five years. To facilitate this decision-making process, we will evaluate both machines using the accounting rate of return, payback period, and net present value methods. Subsequently, we will provide an informed recommendation and discuss the potential impact of discounted payback periods on the decision.
Accounting Rate of Return (ARR)
The Accounting Rate of Return, or ARR, gauges the profitability of an investment by comparing average accounting profits to the initial investment. While this method is relatively straightforward, it neglects the time value of money and cash flows.
For Machine X: ARR = (Average Annual Accounting Profit / Initial Investment) * 100 = ((5 * N$30,000) / N$300,000) * 100 = 50%
For Machine Y: ARR = ((5 * N$56,000) / N$350,000) * 100 ≈ 80%
Payback Period
The payback period, although simple, considers only the time required to recover the initial investment without regard to profitability beyond that point. This method might not align with the company’s long-term financial goals.
For Machine X: Payback Period = Initial Investment / Annual Cash Flow = N$300,000 / N$30,000 = 10 years (not meeting the requirement)
For Machine Y: Payback Period = N$350,000 / N$56,000 ≈ 6.25 years (not meeting the requirement)
Net Present Value (NPV)
The Net Present Value method accounts for the time value of money and provides insight into the investment’s potential value by comparing the present value of cash inflows to the present value of cash outflows.
NPV = Σ [Cash Flow / (1 + r)^t] Where r = discount rate, t = time period
For Machine X: NPV_X = (N$30,000 * 0.909) + (N$30,000 * 0.826) + (N$30,000 * 0.751) + (N$30,000 * 0.683) + (N$80,000 * 0.621) – N$300,000 ≈ N$51,490
For Machine Y: NPV_Y = (N$56,000 * 0.909) + (N$56,000 * 0.826) + (N$56,000 * 0.751) + (N$56,000 * 0.683) + (N$126,000 * 0.621) – N$350,000 ≈ N$103,710
Recommendation
Considering the financial metrics evaluated, Machine Y outperforms Machine X in terms of ARR, Payback Period, and NPV. The ARR for Machine Y is significantly higher, indicating stronger profitability. While both machines fail to meet the four-year payback period requirement, Machine Y has a shorter payback period than Machine X, making it relatively more appealing. Moreover, the NPV of Machine Y is substantially higher than that of Machine X, implying greater potential value creation. Hence, Machine Y seems to be the more promising investment choice.
Discounted Payback Period
The discounted payback period incorporates the time value of money by considering the present value of cash flows. This metric could potentially influence the decision by favoring investments that yield quicker returns in terms of present value.
For Machine X: Discounted Payback Period_X = 3 + (N$80,000 * 0.621) / N$30,000 ≈ 3.5 years
For Machine Y: Discounted Payback Period_Y = 2 + (N$126,000 * 0.621) / N$56,000 ≈ 4.22 years
Impact of Discounted Payback Period
The introduction of discounted payback periods slightly shifts the favor towards Machine X, as it now meets the four-year requirement, whereas Machine Y does not. However, given that Machine Y still exhibits stronger ARR and NPV figures, it remains the more appealing option from a broader financial perspective.
In conclusion, after a comprehensive evaluation of accounting rate of return, payback period, and net present value, Machine Y emerges as the recommended investment choice for Operation Kalahari Desert Ltd. Its superior financial performance in terms of ARR, NPV, and potential long-term profitability underscores its suitability for the organization’s goals. While discounted payback periods introduce a nuanced perspective, the fundamental financial indicators continue to validate Machine Y’s viability as the
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