August 9, 2012
When it comes to capital investing many techniques can be used. Picking the right technique for a company can be a long draw out process. “Once a company purchases a capital asset, it is committed to that investment for an extended period of time” (Edwards, 2007). Guillermo Furniture wants to discover the technique will provide the greatest returns. There are two major capital investing techniques. One is net present value (NPV), and one is internal rate of return (IRR). “Managers can choose from among numerous analytical techniques to help them make capital investment decisions. Each technique has ...view middle of the document...
The internal rate of returns deals with the rate of return on a project and not the desire rate of return. This tech
Net Present Value vs. Internal Rate of Return
“The net present value (NPV) and the internal rate of return (IRR) could as well be defined as two faces of the same coin as both reflect on the anticipated performance of a firm or business over a particular period of time” (Difference Between, 2012). The main difference is that net present value deals with currency or cash as internal rate of return deals with the percentage of value that the capital budget is worth. Another difference is that internal rate of return cannot be used conclusively that have circumstances which the cash flow is inconsistent. This would be no problem for net present value to handle.
Capital Budget Technique Recommendation and Rationale for Choice of Technique.
The recommendation that Guillermo Furniture should use is the net present value. First of The only good time to use the internal rate of return is for a short period of time and Guillermo Furniture wants to know its capital budgeting for the long haul. “As much as discrepancies in discounts will most likely lead to similar recommendations from both methods, it is important to
note that the NPV method can evaluate big long-term projects better as opposed to the IRR which gives better accuracy on short term projects with consistent inflow or outflow figures” (Difference Between, 2012).
Net Present Value Calculations
Here is the calculation for the recommend technique. With the recommendation Guillermo should go with the high-tech equipment. The calculation is shown in the following table.
| | | |
|Cost of Equipment |-450,000 | |
|Year One Net Cash Flow |135,000 | |
|Year Two Net Cash Flow |145,000 |Includes Equipment Overhaul |
|Year Three Net Cash Flow |130,000 | |
|Year Four Net Cash Flow |145,000 | |
|Year Five Net Cash Flow |150,000 |Includes Salvage Amount |
| | | |
| | | |
|Return Rate |Zero | |
| | | |
|NPV |111,179.13 | |
It is hard to pick a capital project to...