Company X has recently been approached with the idea of purchasing new manufacturing equipment. The new equipment will require the investment of $1,300,000, but will result in incoming cash flows for the next five years. The finance department has generated the numbers for this capital budgeting project and set a number of requirements. Specifically, the project must enjoy a 14% rate of return and a payback period of less than five years.
There are three key terms to consider in the evaluation of this new opportunity: payback period, net present value, and internal rate of return. The payback period is the number of years it will take to recoup the cost of the original investment. In the case of the new manufacturing equipment, the initial investment in year 0 is $1,300,000. Incoming cash flows of $500,000, $350,000, and $475,000 in the first three years will result in a payback period of just over 2 years. To determine the exact timeframe based on the estimated incoming cash flows the ratio of necessary capital required to reach a total of $1,300,000 in year 3 must be divided by the total incoming cash for the entire year. That number can be added to 2 and gives a result of 2.94 years for the payback period.
Lawrence J. Gitman (2009) defines the net present value as the value “found by subtracting a project’s initial investment from the present value of its cash inflows discounted at a rate equal to the firm’s cost of capital” (p. 429). In other words, the net present value weighs the initial investment against the present value for the capital over the anticipated time period. Since the present value is already discounted based on the cost of capital, the net present value gives a true value for the result of the investment. If the net present value is the deciding factor for a proposed project, any value over $0 means the project should be accepted. Results under $0 represent a loss and must be rejected (Gitman, 2009).
The internal rate of return is another financial decision-making tool that relates to the net present value. Although the internal rate of return is somewhat complicated to calculate, it represents the discount rate necessary to make the net present value equal to $0. In other words, it is the rate of return the company will receive if it makes the investment in the project. The rule of thumb is that the internal rate of return must be greater than the cost of capital in order to accept the proposed project (Gitman, 2009).
Understanding these key financial terms is necessary for making an educated decision regarding the proposed purchase of new manufacturing equipment. Although the usual indicators for success are positive, this investment does not meet all the requirements set forth by the finance department. The net present value is greater $0 and the internal rate of return exceeds the 6% weighted average cost of capital. Unfortunately, the finance department requires a 14% rate of return and this project can only expect 13%. This number is calculated by subtracting the weighted average cost of capital from the internal rate of return. Therefore, based on the criteria set forth by the finance department, this project should not be accepted.
Gitman, L. J. (2009). Principles of managerial finance (12th ed.). Boston: Pearson.