Capital Investment Decision

Buy or lease option

The decision on whether to buy or lease on an equipment for a certain project would depend on the profitability of each option. The management of the project should select an option that is most profitable. The net present value criteria will be used to compare the project. When using the net present value criteria, it will assume that reinvestment rate is the same as the cost of capital (Holmes & Sugden 2008).

Net present value

Net present value measures the difference between the present value of net cash flow. That is, it measures the present value of the net benefit from a project. This technique looks at both benefits and cost of a project. Also, it takes into account the time value of money. This is necessary because one dollar now might not have the same value in the future (Haber 2004). A project is accepted if the net present value of total incremental cash flow is positive. However, if the total is negative, the a project manager needs to reject the project (McLaney & Atrill 2008). The net present value method will involve selection of a rate which is acceptable to the management or that equals the cost of finance.

Leasing

The table below summarizes the net present value of the project when the company decides to lease.

Year Cost of leasing Incremental revenue Net cash flow After tax cash flow Discount rate at 10% Present value
1 1,500,000 3,500,000 2,000,000 1,200,000 0.9091 1,090,909.09
2 1,500,000 3,500,000 2,000,000 1,200,000 0.8264 991,735.54
3 1,500,000 3,500,000 2,000,000 1,200,000 0.7513 901,577.76
4 1,500,000 3,500,000 2,000,000 1,200,000 0.6830 819,616.15
5 1,500,000 3,500,000 2,000,000 1,200,000 0.6209 745,105.59
NPV 4,548,944.12

Buying

Upon purchase of equipment, a company will receive a tax incentive in the years purchase only.

Year Initial cost Cost of operation Depreciation Total cost Incremental cash flow
0 4,000,000 4,000,000
1 150,000 800,000 950,000 3,500,000
2 150,000 800,000 950,000 3,500,000
3 150,000 800,000 950,000 3,500,000
4 150,000 800,000 950,000 3,500,000
5 150,000 800,000 950,000 3,500,000
Total

Continuation of buying

Year Net income After tax revenue Cash flow Discount rate Net present value
0 (4,000,000) (2,400,000) (2,400,000) 1 (2,400,000.00)
1 2,550,000 1,530,000 2,330,000 0.9091 2,118,181.82
2 2,550,000 1,530,000 2,330,000 0.8264 1,925,619.83
3 2,550,000 1,530,000 2,330,000 0.7513 1,750,563.49
4 2,550,000 1,530,000 2,330,000 0.6830 1,591,421.35
5 2,550,000 1,530,000 2,330,000 0.6209 1,446,746.68
Total 6,432,533.17

From the tables above, the decision to buy yields a higher net present value than the decision to lease at 10% cost of capital. Therefore, it will be beneficial to buy the equipment rather than leasing

Net present value at different discount rates

Leasing

Year Discount rate at 12% Present value Discount rate at 15% Present value Discount rate at 20% Present value
1 0.892857143 1,071,428.57 0.869565217 1,043,478.26 0.83333333 1,000,000
2 0.797193878 956,632.65 0.756143667 907,372.40 0.69444444 833,333
3 0.711780248 854,136.30 0.657516232 789,019.48 0.5787037 694,444
4 0.635518078 762,621.69 0.571753246 686,103.89 0.48225309 578,704
5 0.567426856 680,912.23 0.497176735 596,612.08 0.40187757 482,253
NPV 4,325,731.44 4,022,586.12 3,588,735

From the table above, it is evident that as the discount rate increases, the net present value of the declines. The net present value at 12% amounts to $4,325,731.44, at 15% it amounts to $4,022,586.12 and at 20% the discount rate amounted to 3,588,735.

Buying

Year Discount rate at 12% Present value Discount rate at 15% Present value Discount rate at 20% Present value
0 1 (2,400,000) 1 (2,400,000) 1 (2,400,000)
1 0.89285714 2,080,357 0.869565 2,026,087 0.833333 1,941,667
2 0.79719388 1,857,462 0.756144 1,761,815 0.694444 1,618,056
3 0.71178025 1,658,448 0.657516 1,532,013 0.578704 1,348,380
4 0.63551808 1,480,757 0.571753 1,332,185 0.482253 1,123,650
5 0.56742686 1,322,105 0.497177 1,158,422 0.401878 936,375
Total 5,999,129 5,410,521 4,568,126

As indicated in the above table, as the discount rate increases, it is apparent that the net present value decreases. Also, as the discount rate increases, the option to buy the equipment yields higher NPV than the option to lease.

Part two: group section

How companies make capital investment decisions

Investment decisions require adequate review before injecting funds into the investments for several reasons. The first reason is that capital investments require a large amount of initial capital outlay. Secondly, the benefits of such investments flow in for a long period (Vance 2003). Thirdly, capital investment decisions in most cases deal with an organization’s optimal capital structure that is, in terms sourcing for funds either of debt and equity. Therefore, analysis of the project should be done before searching for funds. Therefore, these projects are irreversible (Siddidui 2005). Finally, capital is a limited resource. There are competing demands for capital therefore, funds should only be channeled to most viable ventures.

Some of the methods that are used to select projects are net present value, internal rate of return, profitability index, payback period, discounted payback period, and accounting rate of return. These methods give different measures and have various pros and cons. A suitable method should take into account the time value of money and cash flow for the entire project (Weiss 1998).

How the project contributes to earnings

The calculation of the project shows that the the project will yield a total net present value amounting to 6,432,533.17 for the whole project. The earnings of the company will increase by the amount revenue from the project. The company will incur costs in the purchase of the equipment. The amount of purchase will be capitalized while the depreciation will be expensed. An increase in profitability increases the return on equity.

Financial health of the company

Working capital and current ratio

Working capital is a measure of efficiency of a company. It is also a short term measure of the financial health of a company. Working capital is the difference between current assets and current debt. Working capital indicates whether the company has adequate current assets than can pay off current liabilities. The total working capital of the project is $750,000. Since it is positive it implies that the company has a sound financial health. Current ratio is a measure of liquidity. It is the ratio of current assets and current liabilities. Since the working capital is positive, it implies that the current ratio is also favorable. Therefore, the company has sound financial health.

Recommendations on lease or buy decision

The company has sound financial health and it can undertake the project. At a discount rate that is less than 20%, the option to buy yields higher returns than option to sell. Therefore, the company should buy the equipment. However, at very higher discount rates, the present value of future benefits will diminish, thus yielding negative NPV under the option to buy. In such cases, leasing would be a viable option. Other factors such as the availability of capital, market demand productivity, and the nature of the industry should be factored into making the decision to buy or lease.

References

Haber, R. (2004). Accounting dimistified. New York: American Management Association.

Holmes, G., & Sugden, A. (2008) Interpreting company reports. New York: Financial Times/Prentice Hall.

McLaney, E., & Atrill, P. (2008). Financial accounting for decision makers. New York: Prentice Hall Europe. New York.

Siddiqui, A. (2005). Managerial economics and financial analysis. New York: New age international (P) limited.

Vance, D. (2003). Financial analysis and decision making: Tools and techniques to solve. New York: McGraw-Hill books.

Weiss, L. (1998). How to understand financial analysis. New York: Insead-Fointaneblea.

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