Investment Appraisal for Miggy and Brothers Co - Essay Example

Running Header: INVESTMENT APPRAISAL FOR MIGGY & BROTHERS CO. Investment Appraisal for Miggy and Brothers Co. in APA Style by 's Name Course Name University 1.0 Introduction: The Case Miggy and Brothers Co (MBC) is a manufacturing firm specializing in the production of customized furniture. In order to increase its production efficiency, the company standardizes some of the components of the furniture. The machine used for this purpose is a five year old Mitsui XCM sourced from the Japan. The company is having some problems with the performance of Mitsui XCM and plans to sell the machine in order to acquire a more efficient one. The finance department of MBC estimates that the current machine has a market value of $5000. In evaluating its investment decisions, MBC uses a 12% cost of capital. MBC is considering three alternatives as replacements: model A which will be sourced from the United States; Model B which is a British machine; and model C which will be imported from France. All of these machineries cost $100,000 and are seen to improve the production efficiency of the company and reduce the costs incurred in manufacture. As these are new machines, MBC will be hiring and training personnel who will operate the new equipment. Exact amount is not yet determined but Model C, in particular is expected to incur the highest training cost since the machine is least user-friendly. Models A & B have local dealer which agree to maintain and repair the machines for MBC. In the case of Model C, MBC needs to seek French manufacturers to service the machine in case of emergencies. Table 1 shows the expected annual cash flows of the three alternatives. It should be noted that the 6th year cash of Model A augments its estimated salvage value of $15,000. Table 1. Estimated Cash Flow of the Three Machines 2.0 Considerations The choice between the three machines under consideration can be justified by utilizing tools which tests the profitability of each investment. Three of the most frequently used assessment tools will be employed in MBC decision making. These are payback period, net present value analysis, and internal rate of return analysis. Aside from the quantitative data given by the management, this report adjusted the figures to enhance the rationale of the choice. In this regard, the salvage value of the old machine to be replaced is reflected as cash flows in Models A, B, and C. It should be noted that as the acquisition of the new machine will entail discarding the old, all options will benefit from the revenue of selling the old one. Due to equity considerations, this report opted to disregard the salvage value of the three machines on the sixth year. Since the salvage value of Models B and C cannot be determined, it is more rational to omit the revenue to be derived from the future sale of the machines. 3.1 Payback Period The payback period is one of the simplest ways in ascertaining the feasibility of an investment. This tool is used to determine the length of time that the company can recoup its cash outlay (Keown, et al, 2005). Table 2 shows the computed payback period for the three options. Table 2. Payback Period Computation From the above computation, Model A has a payback period of 4 years while the company's investment in Models B and C will be recouped within a shorter period of three years. 3.2 Net Present Value Net Present Value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows (Keown, et al, 2005). Table 3. Net Present Value Computation Table 2 shows the computation for the NPV of the three machines under consideration. Model A has an NPV of 6,434 while Models B and C generate discounted cash flows of -7,299 and 16,455, respectively. 3.3 Internal Rate of Return The internal rate of return is the cost of capital which equates the NPV to zero (Keown, et al, 2005). Table 4 shows the different IRR for each model as computed by Microsoft Excel. Consistent with the NPV analysis, Model C has the highest IRR at 19%, followed by Model A with 14%. Model B's IRR is 8% which is relatively lower than MBC's IRR. Table 4. Internal Rate of Return Computation Model A Model B Model C IRR 14% 8% 19% 4.0 Recommendation Quantitative analyses show that Model C or the machine from France is the best choice as it has a relatively shorter payback period of 3 years, an NPV of 16,455, and IRR of 19%. However, using the qualitative information supplied by the managers of Miggy and Brothers Co. Model C is the worst choice as the company will be incurring a high training cost and runs the risk of discontinued operation because of the lack of local maintenance firm to service the machine. These factors can erode the cost savings generated from the machine. It is irrefutable that maintenance services for a machine is very important as it will help the company fully realize the expected gains from Model C. In case of defects, it can be seen that the costs associated with finding a foreign maintenance firm to restore the machine can offset the high NPV and cause disruption in operation. This report recommends that MBC choose Machine A or the machine from USA. Model B is ruled out as it generates a negative NPV. The rationale of the choice is that Model A has a positive NPV though significantly lower compared to Model C. The presence of a local firm to maintain the machine is a significant advantage. Reference Keown, A.J., Martin, J.D., Petty, J.W., and Scott Jr., D.F, (2005) Financial Management principles and applications, Pearson/Prentice Hall International Edition, 10th Edition Read More