This paper will provide a report on the analyses of a proposal to replacement manufacturing equipment, with an additional investment of au$80 thousand in net working capital. The proposal will be assessed against the performance of existing equipment.
The methodologies used for the analysis will be based on discount cashflows and will consider the time value of money. A sensitivity analysis will be completed to address concerns regarding the appropriate required rate of return, with consideration to substantial decreases in to the risk free rate over the years.
The methodologies to be used will be present value analysis, profitability index and internal rate of return. Further to this will a review of two alternate practices, being the accounting rate of return and the payback period.
Lastly will a recommendation to either accept or reject the proposal, based on the results of the analyses.
2. Theoretical background
2.1 Net Present Value Analysis
Net present value (NPV) is dependent on future cash flow and is the difference between cash received and cash paid out (Brealey, Myers & Allen, 2014). The use of NPV assists in determining if a project is worth more than it costs, with the value being estimated by calculating the value of cash flows if traded in capital markets(Brealey, Myers & Allen, 2014) the amount available through the comparable market is referred to as the opportunity cost. NPV is one of the many methodologies used for this purpose, it uses a compound rate of return to discount the future cash flows by using the Present Value Interest Factor (PVIF) to translate the value of future cash flows into today’s equivalent value and is presented as an absolute number, with the rule for projects returning p...
... middle of paper ...
...& Walker, cited in Brealey, Myers & Allen, 2011). According to Gitman et al, (2008), NPV is considered to be less intuitive, due to the amount relative to the invested amount not being measured, whereas other investors prefer it due to the evaluation of the investment project contribution. In contrast, PVA is presented in terms of cash flows with IRR being presented in terms or percentage. Furthermore it is stated that NPV reinvests the cost of capital and determines shareholder wealth, with the assumption that cash flows are reinvested at the cost of capital, whereas IRR assumes the reinvestments at the projects IRR. Brealey, Myers & Allen (2011) state that IRR and PI can be misleading when choosing between mutually exclusive projects, as shown in figure 2, IRR would select project D based on the 100%, whereas project E shows a significantly better financial return.
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