Universal Manufacturing Technology Limited’s CEO has decided to purchase a few machineries to improve the company’s operations. However, he is uncertain how to evaluate the machineries.
He has asked your advice on the various techniques to evaluate the investment. Discuss the several methods of investment appraisal techniques considering the methods using time value of money and not using time value of money.
Beside the above, the CEO is also keen to know about the following terms:
(a) Sunk Cost
(b) Relevant Cost
(c) Incremental Cost
(d) Opportunity Cost
In your discussion to the above terms, use appropriate examples.
One of the key areas of long-term decision-making that firms must tackle is that of investment the need to commit funds by purchasing land, buildings, machinery and so on, in anticipation of being able to earn an income greater than the funds committed. In order to handle these decisions, firms have to make an assessment of the size of the outflows and inflows of funds, the lifespan of the investment, the degree of risk attached and the cost of obtaining funds.
Even the projects that are unlikely to generate profits should be subjected to investment appraisal. This should help to identify the best way of achieving the project’s aims. For example, investment appraisal may help the CEO to find the cheapest way to purchase few machinery, even though such a project may be unlikely to earn profits for the company. Investment appraisal techniques are important tools in business decision making. The all suffer the fundamental problem of trying to compare the known with the expected.
There are various methods of investment appraisal such as method that not using time value of money (Payback method, Accounting rate of return(ARR) , etc) and method that using time value of money (Net Present Value (NPV), Internal rate of return (IRR), etc).
Method that not using time value of money:
i. Payback Method ii. Acounting rate of return (ARR)
This is literally the amount of time required for the cash inflows from a capital investment project to equal the cash outflows. The usual way that firms deal with deciding between two or more competing projects is to accept the project that has the shortest payback period. Payback is often used as an initial screening method.
Payback period =
Annual cash inflow
So, if $4 million is invested with the aim of earning $500,000 per year per year (net cash earnings), the payback period is calculated
Payback period = $4,000,000