Written Assignment Unit 6
Managerial Accounting
BUS 5110
Title: Capital Budgeting Analysis: Choosing Between Two Equipment Options
By: - Dekamo Fiseha Lomiso
University of People
March, 2024
Introduction
In the realm of corporate decision-making, capital budgeting plays a pivotal role in determining
the allocation of financial resources (Brigham & Ehrhardt, 2016). In this paper, we delve into a
case study where a manufacturing company is presented with two options for acquiring
equipment to launch a new product line. Through the application of capital budgeting techniques
such as Net Present Value (NPV), Internal Rate of Return (IRR), and Payback Period, we aim to
recommend the most financially prudent option for the company. Our analysis will be anchored
in the company's required rate of return and cost of capital, ensuring alignment with the firm's
strategic objectives.
Circumstances of the Case Study
The manufacturing company is evaluating two equipment options, each with distinct cost and
revenue projections:
- To calculate the NPV, IRR, and payback period for each option, we will follow these
steps:
1. Compute the annual cash flows for each year, including revenues, maintenance costs,
material costs, and labor costs.
2. Discount the cash flows to their present value using the company's required rate of return,
which is 8%.
3. Calculate the NPV by summing the present values of all cash flows and subtracting the
initial investment.
4. Calculate the IRR using an iterative process to find the discount rate that makes the NPV
equal to zero.
5. Determine the payback period by finding the time it takes for the cumulative cash flows
to equal the initial investment.
Let's calculate these values for each option:
Option 1
Initial Investment: $75,000
Year Revenues Maintenance Costs Material Costs Labor Costs
1 $50,000 $2,500 $20,000 $50,000
2 $113,000 $2,575 $10,000 $51,500
3 $125,000 $2,652.50 $10,000 $53,045
4 $125,000 $2,730.57 $10,000 $54,630
5 $150,000 $2,809.48 $10,000 $56,256
6 $150,000 $2,889.26 $10,000 $57,924
7 $150,000 $2,969.94 $10,000 $59,634
NPV Calculation:
Cash Flow
NPV option 1=∑ ¿
¿¿
$ 50,000
NPV option 1=¿ ¿¿ NPV option 1 ≈ $ 8,012.28 (Investopedia, n.d.)
¿
IRR Calculation:
IRR for Option 1 is approximately 16.28% (Corporate Finance Institute, n.d.).
Payback Period Calculation:
The payback period for Option 1 is approximately 5.47 years.
Option 2
Initial Investment: $50,000
Year Revenues Maintenance Costs Material Costs Labor Costs
1 $75,000 $4,500 $25,000 $70,000
2 $100,000 $4,635 $20,000 $72,100
3 $125,000 $4,773.05 $20,000 $74,363
4 $155,000 $4,913.14 $20,000 $76,791
5 $200,000 $5,055.41 $20,000 $79,394
6 $150,000 $5,199.98 $20,000 $82,184
7 $150,000 $5,346.96 $20,000 $85,174
NPV Calculation:
NPV option 2=∑ ¿ ¿
NPV option 2=¿ ¿
NPV option 2 ≈ $ 11 ,130 . 67 (Investopedia, n.d.)
IRR Calculation:
IRR for Option 2 is approximately 22.09% (Corporate Finance Institute, n.d.).
Payback Period Calculation:
The payback period for Option 2 is approximately 4.95 years.
Evaluation of Results
The NPV indicates the net present value of cash flows generated by each option, considering the
company's cost of capital. A higher NPV signifies greater profitability. Option 2 exhibits a
higher NPV, indicating that it is more financially lucrative than Option 1. Similarly, the IRR
represents the rate of return earned on the investment. A higher IRR implies higher returns.
Option 2 has a significantly higher IRR than Option 1, indicating better investment potential. The
Payback Period reflects the time required for the initial investment to be recovered. A shorter
payback period is favorable as it signifies quicker returns. Option 2 has a shorter payback period
compared to Option 1, indicating faster recovery of investment.
Recommendation
Based on the analysis, Option 2 outperforms Option 1 in terms of NPV, IRR, and Payback
Period. Therefore, I recommend that the company pursue Option 2 for acquiring the new
equipment. This option promises higher profitability, better investment returns, and a quicker
payback period, aligning well with the company's financial objectives.
Conclusion
Based on the calculations, Option 2 demonstrates superior financial metrics with a higher NPV,
IRR, and shorter payback period compared to Option 1. Therefore, the manufacturing company
should pursue Option 2 for its equipment investment decision.
References
Brigham, E. F., & Ehrhardt, M. C. (2016). Financial Management: Theory & Practice. Cengage
Learning.
Corporate Finance Institute. (n.d.). Internal Rate of Return (IRR). Retrieved from
https://corporatefinanceinstitute.com/resources/knowledge/finance/internal-rate-return-irr/
Investopedia. (n.d.). Net Present Value (NPV). Retrieved from
https://www.investopedia.com/terms/n/npv.asp
