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In order to determine the feasibility of a project and to allow for comparisons between those that are mutually exclusive several very useful and highly recognised techniques are available. They include: I. Net present value (NPV) II. Internal rate of return (IRR) III. Accounting Rate of Return (ARR); and IV. Simple payback There are three (3) machines that the firm is considering as an investment. They are the Alumier which it currently uses; Big EZ and Cial. The objective of evaluating these investments is to determine which would be more beneficial to the firm. Evaluating Capital Budgeting Tools The NPV, IRR, ARR and simple payback. The advantages and disadvantages of using these methods are noted weaknesses and the relevant calculations to aid in the decision process are noted. Net Present Value (NPV) The net present value takes the time value of money into account and so the cash flows are discounted over the useful life of the asset. A NPV of zero means that the cash flow from the project would be sufficient to repay the initial investment only but would not contribute anything extra. A NPV that is less than zero (negative) would indicate that the funds generated from the project cannot generate sufficient funds to repay the initial investment and therefore should not be undertaken. On the other hand a positive NPV indicates that the project would be able to repay the initial investment and also allow some returns to shareholders (Brigham and Ehrhardt 2005). A positive NPV therefore means that the project under consideration is a worthwhile investment and should be undertaken. This method is very popular but has a number of shortcomings. Titman et al (2011) indicates that in case of capital rationing the NPV is not the deal method as choosing the projects with the highest profitability but not the highest NPV overall when compared to a number of smaller projects. Additionally some of the budget may be left unused. The formula for calculating the NPV is: NPV = CF0 + ((CF1/(1 + ...Show more

Summary

To: The Board of Directors of Lambert Heating From: Financial Advisor Subject: Capital Budgeting Date: May 24, 2013 Report Introduction Capital budgeting involves the use of various tools to evaluate future cash flow. Emery et al (2007) indicates that firms evaluate expected cash flow in relation to the initial sums expended in making the investment…
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