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.
Operation Kalahari Desert Ltd is presented with an opportunity to enhance operational efficiency by investing in a new machine. The company is considering two options, Machine X and Machine Y, each with distinct financial implications. This essay aims to evaluate the investment options using various methods, such as the accounting rate of return, payback period, and net present value, in order to provide well-informed advice to the management regarding the best course of action.
Accounting Rate of Return (ARR) using Average Capital Invested: The Accounting Rate of Return calculates the average annual accounting profit as a percentage of the average capital invested. It is a simple yet flawed method as it does not consider the time value of money or cash flows. For Machine X, the ARR can be calculated as [(Average Annual Savings / Average Capital Invested) * 100], and similarly for Machine Y. However, this method does not provide a comprehensive understanding of the investment’s financial viability.
Payback Period (using Cash Flows): The Payback Period is the time it takes for an investment to recoup its initial cost. It is calculated by dividing the initial investment by the annual cash flows. For Machine X and Y, the payback period can be found by dividing their initial costs by their respective annual cost savings. While this method provides a basic understanding of how quickly the investment could pay off, it doesn’t consider cash flows beyond the payback period and ignores the time value of money.
Net Present Value (NPV): The Net Present Value method considers the time value of money by discounting future cash flows back to their present value using the company’s cost of capital. The formula for NPV is ∑[(Cash Flow / Discount Factor) – Initial Investment]. By calculating NPV for both Machine X and Y and comparing the results, we can determine the investment’s profitability. A positive NPV indicates that the investment is expected to generate more value than the initial cost.
Considering the provided financial information, it’s essential to provide advice to the management regarding which machine to purchase. To make an informed decision, the NPV method is recommended due to its incorporation of the time value of money and comprehensive consideration of cash flows. By calculating the NPV for both Machine X and Y and comparing the results, management can assess which investment option aligns better with the company’s financial goals.
The Discounted Payback Period considers the discounted cash flows instead of nominal cash flows. This method calculates the time required to recover the initial investment using discounted cash receipts. Calculating the Discounted Payback Period for both Machine X and Y by dividing their initial investments by the sum of discounted cash flows provides a more accurate understanding of how long it will take for the investments to become profitable in present value terms.
However, the discounted payback period may not significantly affect the advice provided in section B. The NPV method already incorporates the time value of money, providing a more robust evaluation of the investment options. While the discounted payback period can offer additional insight into the timing of cash flows, the fundamental decision-making process is unlikely to be altered.
In conclusion, evaluating the investment options using the accounting rate of return, payback period, and net present value methods provides a holistic view of the potential financial gains. While each method has its advantages and limitations, the NPV method is recommended due to its consideration of the time value of money and comprehensive assessment of cash flows. Machine X or Y should be selected based on their respective positive or negative NPV values. The discounted payback period, though insightful, is unlikely to significantly change the decision-making outcome derived from the NPV analysis.
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