Discussion Question You Have Been Asked By The Owner

Discussion Question Oneyou Have Been Asked By The Owner Of Your Compa

Discussion Question One: You have been asked by the owner of your company to advise her on the process of purchasing some expensive long-term equipment for your company. Give a discussion of the different methods she might use to make this capital investment decision. Explain each method and its strengths and weaknesses. Indicate which method you would prefer to use and why. The textbook been used in this class is Warren, C., Jones, J. P., Tayler, W. B. (2019). Financial and Managerial Accounting (15th ed.). Boston: Cengage. ISBN:

Paper For Above instruction

Making informed decisions regarding the acquisition of long-term equipment is critical for the financial health and strategic growth of a company. When a company considers purchasing expensive long-term equipment, it must evaluate various investment decision-making methods to select the most suitable one that aligns with its financial goals and risk appetite. The primary methods used in capital budgeting include the Payback Period, Accounting Rate of Return (ARR), Net Present Value (NPV), and Internal Rate of Return (IRR). Each approach offers unique insights and faces distinct limitations, thus requiring careful analysis before implementation.

Payback Period Method

The Payback Period method measures the time required for the initial investment to be recovered through cash inflows generated by the asset. It is straightforward, emphasizing liquidity and risk mitigation, especially pertinent for companies with limited cash flow or high-risk environments. For example, if a piece of equipment costs $100,000 and generates annual cash inflows of $25,000, the payback period is four years. Its simplicity makes it popular; however, it ignores the time value of money and does not consider cash flows beyond the payback horizon, potentially leading to suboptimal investment choices.

Accounting Rate of Return (ARR)

The ARR computes the return on investment by dividing the average annual accounting profit by the initial investment cost. It is easy to calculate and understand, serving as an initial screening tool. For instance, an equipment costing $100,000 with an average annual profit of $10,000 results in an ARR of 10%. Despite its simplicity, ARR neglects the time value of money and cash flow timing, which may distort the actual profitability and lead to poor decision-making.

Net Present Value (NPV)

NPV assesses the profitability of a project by calculating the difference between the present value of cash inflows and outflows, discounted at the company's required rate of return. A positive NPV indicates value creation, making it a preferred method among financial managers. For example, discounting future cash flows at 8% might yield an NPV of $15,000, suggesting the investment is beneficial. Its strengths lie in considering the time value of money and providing an absolute value measure. However, NPV requires accurate estimation of future cash flows and an appropriate discount rate, which can be complex and uncertain.

Internal Rate of Return (IRR)

IRR identifies the discount rate at which the present value of cash inflows equals the initial investment, effectively reflecting the project's rate of return. If the IRR exceeds the company's required rate, the project is acceptable. For example, an IRR of 12% compared to a 10% hurdle rate indicates profitability. IRR accounts for the time value of money and is useful for comparing multiple projects. Nevertheless, it can produce multiple or conflicting results in non-conventional cash flow situations and does not directly measure the dollar value added.

Preferred Method and Rationale

Among the discussed methods, the Net Present Value (NPV) is generally considered the most comprehensive and financially sound approach. It explicitly incorporates the time value of money, provides a clear measure of added value, and aligns with maximization of shareholder wealth. While other methods like payback period and ARR serve as useful supplementary tools, they lack considerations for discounted cash flows, potentially leading to less accurate investment decisions. Therefore, I recommend using NPV as the primary evaluation criterion when advising the company owner on purchasing long-term equipment. This approach ensures that the investment contributes positively to the company's long-term financial sustainability and growth.

Conclusion

Effective capital investment decisions require a balanced assessment of various methods considering their strengths and limitations. Employing NPV as the key decision-making tool, complemented by payback period and ARR for additional insights, enables a comprehensive evaluation that supports optimal investment choices aligned with the company's strategic objectives and financial capacity.

References

• Warren, C., Jones, J. P., & Tayler, W. B. (2019). Financial and Managerial Accounting (15th ed.). Boston: Cengage.
• Brigham, E. F., & Houston, J. F. (2019). Fundamentals of Financial Management. Cengage Learning.
• Ross, S. A., Westerfield, R. W., & Jaffe, J. (2019). Corporate Finance. McGraw-Hill Education.
• Damodaran, A. (2015). Applied Corporate Finance. Wiley.
• Gitman, L. J., & Zutter, C. J. (2015). Principles of Managerial Finance. Pearson.
• Agrawal, N., & Naik, P. (2021). Evaluation of capital budgeting methods: A review. Journal of Financial Management, 17(3), 245–262.
• Myers, S. C. (2019). Capital budgeting and investment analysis. Financial Analysts Journal, 75(2), 6–19.
• Keown, A. J., Martin, J. D., & Petty, J. W. (2018). Financial Management: Principles and Practice. Pearson.
• Higgins, R. C. (2020). Analysis for Financial Management. McGraw-Hill Education.
• Ross, S. A., & Westerfield, R. W. (2021). Principles of Corporate Finance. McGraw-Hill Education.