The financial feasibility of a capital expenditure. Pevensey Plc Essay

The financial feasibility of a capital expenditure. Pevensey Plc - Essay Example The head of the production department has approved all the short listed machines and now the decision rests with the financial control unit in order to evaluate the financial feasibility of the purchasing decision. Future cash flows have been forecasted and are presented as net cash inflows. The cash outflows comprises of expected repair and maintenance expenditure over the useful life of the asset. Whereas, the cash inflows includes the expected total revenue generated by the machines in the form of sale of the products manufactured by the machine. All the projected cash flows include the impact of expected inflation. The capital expenditure pertaining to the purchase of machine has been decided to be funded through internally generated funds. Therefore, keeping into consideration the limited amount of the funds, the directors of the company must make prudent investment decision so to achieve the most lucrative and appropriate results. The method used in the investment appraisal is determining the Net Present Value (NPV) of each proposal. According to this method, the future expected cash flow, over the time span of the project, are discounted based on the expected discount rate in the economy. As per the treasury department of the company, the cost of capital of the company is 9%, which is used as the discount rate in calculating the NPV of each project. The expected cash flow from each year is multiplied by the discount factor to arrive at the present value at year 0 i.e. at the time of making of the capital expenditure. An investment whose NPV is positive is considered to be a rewarding one, whereas an entity does not venture on an investment where the NPV of the cumulative cash flows is negative. Where the management has to rank the investments, with the objective of giving priority to the most rewarding ones, the investment with the highest NPV must be ranked first. Calculating Internal Rate of Return (IRR) is another method extensively used in the investment appraisals. IRR is a rate where the cost of investment, cash outflow, is equal to the cash inflows. The proposal with the highest IRR is considered to be the most rewarding one. Payback period is another method utilized in investment appraisal which calculates the time taken by the investment to generate enough cash inflows to recover the initial cost of the investment. Investment appraisal through NPV method and IRR method are both very useful in order to financially attractive prospective of any investment decision. A good financial analysis is based on the trade off between these two methods. However, practically the IRR method is used widely in investment appraisal decision. The prime reason behind selecting the IRR method of appraisal is it is comparatively straight forward and can be used without having a prior experience in capital budgeting. NPV method has certain drawbacks and limitations. Different projects must be assesse d at different discount rates because the risk for each project is generally different. The reliability of the NPV based investment appraisal can be as reliable as the discount rate itself. However, in practice, it is very unrealistic to determine different discount rate for different investment proposals. Whereas, IRR uses a single discount rate to evaluate every investment, due to which it is used extensively among the financial analysts. With certain disadvantages, the NPV method comes with several attributes which makes it superior to the IRR method. IRR method of appraisal is for evaluating the financial result of an investment over a short period of time. Moreover, IRR is also ineffective for investments proposals which are a mixture of positive and negative cash flow. For these