Managerial Finance: Analysis Of Different Alternatives

Evaluation of Different Alternatives under Three Methods of Project Evaluation

The project appraisal is a structured approach which starts from estimating the future cash inflows and outflows and ends with determining the financial viability of the project. There are different methods being used in assessing the project’s financial viability such as net present value, internal rate of return, and payback period. Each method has its own peculiarities and therefore, none of these can be said to be superior to the other (Ehrhardt and Brigham, 2008). It depends upon the situation as to which method is to be applied in assessing the project’s financial viability. In this context, this report has been prepared for Needle Manufacturing to analyze three alternatives in regard to the machine replacement decision. There are three different machines being considered to replace the current one.        

Net Present Value Method

The net present value method is the most commonly applied method for the purpose of evaluation of the project’s financial viability. Under this method, the net present value is computed by deducting the present value of all cash outflows from the present value of cash inflows of the project. The project having highest positive net present value is considered the most appropriate and hence selected for implementation (Ehrhardt and Brigham, 2008). The net present value method produces analysis of profitability of the project which is primary advantages of this method. It becomes easier to measure the contribution of project to the shareholder’s worth by analyzing the project under net present value method. The biggest disadvantage of net present value method is that it does not fit for analysis when the projects being analyzed are of different sizes. Further, the analysis of net present value also does not provide the rate of return earned by the investors as provided by the internal rate of return method (Ehrhardt and Brigham, 2008). In regards to the Needle Manufacturing, the analysis of the net present value of three different machines is presented in the tables given below:      

The results of the analysis conducted above depicts that the alternative-1 with Alph Machine is yielding a net present value of $32,347.18. The alternative-2 with Beat Machine is yielding net present value of $-17732.10 while the alternative-3 with Camn machine is yielding net present value of $65,795.65. It could be observe that the alternative-3 with Camn machine is yielding the highest net present value. Therefore, based on the net repent value it could be analyzed that the alternative-3 would be first choice in front of the management for replacement of the old machine.     

Net Present Value Method

The internal rate of return (IRR) method provides computation of the rate of return that the investor will yield on the amount invested (Gitman, 2007). This method is considered superior than the accounting rate of return because it takes into consideration the time value of money. In the internal rate of return method, the project’s IRR is compared with the company’s required rate of return and the project yielding highest IRR is considered the best for implementation. The internal rate of return method is simple in interpreting the results and understanding the outcome. However, it may be computationally very difficult in the situations of unconventional cash flows. In the cases when the stream of cash flows involves both cash inflows as well as outflows over the entire period of the project, the computation of IRR becomes difficult. Further, the analysis of different size projects by applying IRR method is not considered appropriate (Gitman, 2007). In regard to Needle Manufacturing, the computation of IRR for all three alternatives is given as below:      

The results of the analysis presented above show that the payback period of alternative-1 with Alph machine is 5.66 years. Further, the payback period of alternative-2 with Beat machine has been found to be 6 years. It could be observed that the initial outlay is not even getting recovered fully in 6 years time period in case of alternative-2. The cash outflow of $17,732.10 is remaining at the end of 6^th year unrecovered. Further, in the case of alternative-3, the payback period has been found to be 4.39 years. It could be observed that the payback period of alternative-3, is the lowest which implies that this alternative is the best choice for the management.         

From the analysis of all three alternatives, it has been observed that the alternative-3 with Camn machine is the best choice available for the management for replacement of the old machine. The alternative-3 has dominated the other two alternatives in the analysis of net present value, IRR, and payback period. The net present value of alternative-3 is $65,795.65, which is highest among all. Further, the IRR of alternative-3 is 14.96%, which is also higher than the other two alternatives. The payback period of alternative-3 is 4.39 years which is the lowest among all. Therefore, it is recommended to the management of Needles Manufacturing that they should replace the old machine with the Camn machine. 

References

Ehrhardt, M and Brigham, E. 2008. Corporate Finance: A Focused Approach. Cengage Learning.

Gitman. 2007. Principles of Managerial Finance, 11/E. Pearson Education India.

Shapiro. 2008. Capital Budgeting and Investment Analysis. Pearson Education India.