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Capital budgeting has been a major concern among many financial managers in virtually all organizations. This is because of the fact that organizations operate under limited resources and, as such, allocate these limited resources to the most optimally viable projects. It is because of this reason that companies carry out investment appraisal before engaging in capital expenditures.
There are several methods that are used to carry out capital investment appraisals, some which are non-financial and others financial. Most finance managers use the financial methods to carry out appraisals because they give the quantitative attributes of a project (Vance 109).
Some of the financial capital appraisal methods include the Net Present value (NPV), the Payback period, the Internal Rate of Return (IRR). This paper analyzes the viability of Abel Athletics consideration to buy new manufacturing equipment that costs $1,300,000.00.
The appraisal methods used are the Payback period, Net Present value (NPV), and Internal Rate of Return (IRR).
The Payback Period
Payback period is defined as the time that a project takes to generate cash revenues that will offset the amount of money invested (Dayananda et al. 69). This method considers a time period that is set by the management to evaluate whether the project will be carried out or not.
A project, that manages to pay back its cash outlay before the set payback period is over, is considered preferable and, as such, the project is accepted. In cases where there are two mutually exclusive projects, the one with a shorter payback period is given the priority (Dayananda et al. 72).
Using this method, the management of Abel Athletic set a payback period of five years. As reported by the finance department, the investment pays back the amount invested in the third year. This means that using the project of the payback period method is acceptable.
Net Present Value (NPV)
This is a discounting method that considers the time value of money. It puts into consideration the fact that the value of a dollar today is more than that of the same dollar at a future date (Wendy and Mayer 98). This rationale is underlined by the fact that there are market condition such as inflation that with time, results in the general fall of the value of the dollar.
This coupled with other factor, such as the investment risk, makes the time value of money become a vital consideration when carrying out investment appraisals (Wild, Subramanyam and Hasley 63).
While appraising using this method, a positive NPV means that the project is acceptable. This is because the present value of the cash flows exceeds the initial amount of cash outlaid. In appraising mutually exclusive projects, the project with bigger NPV is chosen over the one with a small one.
In carrying out the financial appraisal for this project, the finance department reported a positive NPV of $150,768.00. This means that the present value of the cash flows to be received exceeds the amount of cash to be outlaid and, as such, the project appraisal decision is to accept it.
The Internal rate of Return
This is another discounted cash flow appraisal method. It involves setting a required rate of return that projects must offer in order to be considered viable. The internal rate of return is the one which is required to equate the Net Present value to zero (Dayananda et al. 78). If the project’s rate of return is greater than the predetermined one, the project is accepted.
The cash flows in this project have an internal rate of return of 19%. This is above the predetermined benchmark of 14% and, as such, the project is acceptable. From the above analysis, this project is acceptable using all the appraisal techniques provided.
Dayananda, Don. et al. Capital Budgeting: Financial Appraisal of Investment Projects. Cambridge: Cambridge University Press, 2002. Print.
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Vance, David E. Financial Analysis & Decision Making: Tools and Techniques to Solve Management Problems and Make Effective Business Decisions. New York: McGraw HIll, 2003. Print.
Wendy, Carlin and Colin Mayer. “Finance, Investment and Growth.” Journal of Financial Economics (2003): 10-26. Print.
Wild, John, Kasala Subramanyam and Rovert Hasley. Financial Statement Analysis. New York: Mc Graw Hill, 2007. Print.