14

3500

Lambert currently has a choice of investing in either of three machines – Alumier which is a replacement for the current machine, Big EZ – which is supplied by an American firm, and Cal which is manufactured in Japan. The objective of performing an evaluation is to determine which of these three investment options will provide the best return to the shareholders of the firm. The Net Present Value (NPV) According to Ryan and Ryan (2002) the NPV is one of the most preferred investment appraisal techniques. This method strongly rivals IRR as one of the most popular investment appraisal techniques. In fact, Campbell and Brown (2003) indicate that it performs better than IRR in relation to making choices between mutually exclusive projects but needs to be modified in capital rationing decisions and when project choices have unequal lives. Additionally, where projects are not divisible under capital rationing it may be best to invest in several small projects which exhaust the budget but have lower profitability ratios and generates a higher NPV when added together rather than a large project with higher profitability which does not exhaust the budget (Campbell and Brown 2003). .The main focus of the NPV approach is how the value of cash flows is affected by the time in which they are received or paid out. Therefore, tools relating to the time value of money are used to facilitate the comparability of cash flows that takes place in different time periods (Titman et al 2011). Cash flows are discounted at the cost of capital which is 10% in this case. The formula for calculating NPV is as follows: NPV = CF0 + ((CF1/(1 + IRR)1) + ((CF2/(1 + IRR)2) … ((CFn/(1 + IRR)n) The decision rule criteria indicate that projects with a positive NPV should be accepted. In the case of mutually exclusive projects, the project with the highest NPV value should be selected. Information on the NPV for the three investment options are shown in Table 1 in Appendix 1. The information in Table 1 indicates that the Alumier Machine and the Cal Machine will both yield a positive NPV. However, only one machine is required and so the two investments are mutually exclusive. Therefore, the machine with the highest NPV value should be chosen. The Alumina Machine will yield an NPV of? 32,180 compared to? 65,650 for the Cial Machine. The Internal Rate of Return (IRR) The IRR is another very popular and well-recognized investment evaluation technique which along with NPV is rated above the other techniques (Titman et al 2011). It is the discount rate that yields an NPV of zero (Titman et al 2011). The IRR decision rule criterion is to invest in the project if the IRR is greater than the discount rate used in calculating the NPV. One of the most common problems that have been raised about the IRR is the possibility of multiple internal rates which conflict with each other or the possibility of none at all (Hazen 2003). The formula for calculating IRR which is similar to that used in calculating NPV and is given as: NPV = CF0 + ((CF1/(1 + IRR)1) + ((CF2/(1 + IRR)2) … ((CFn/(1 + IRR)n) = 0 This formula is used to find the rate of return where NPV = 0.