Investment Evaluation of Renewla or Replacement of A Machine

Question: Discuss about the Investment Evaluation of Renewla or Replacement of a Machine. Answer: Introduction Lifestyle Furniture is a leading online retailer of solid hardwood furniture. The company provides a large variety of ranges of furniture and wishes to improve its production line by investing in new generation craft machinery. The company is in a dilemma whether to renew the existing machinery or replace it with a new one. Relevant cash flows have been developed for both the options and the respective NPV, IRR and PI have been calculated to decide which option is better in terms of profitability and timely return of investment. An NPV profile has been developed for both the options to see which has a better NPV profile. The incremental cash flows have been later adjusted for the effect of inflation. A base case scenario has been performed for both the alternatives where the companys expected profits have been considered as the base case and depending on these profits, the sales and operating and maintenance costs have been adjusted to see the changes in NPV and other NPV techniques. Investment Evaluation Incremental Operating Cash Flows The incremental operating cash flows have been prepared for both the alternatives by deducting all operating outflows like raw material, overhead, operating costs, advertising and marketing expenses, depreciation and interest on bank loan. The net income has been calculated after deducting taxes. The operating cash flows have been calculated by adding depreciation to net income. The net cash flows have been discounted by the cost of capital. The initial investment for alternative 1 comprises of cost of renewal, opportunity cost of not selling the machine and increase in working capital. The initial investment for alternative 2 comprises of cost of new machine, after tax proceeds from sale of old machine and increase in working capital. There is a terminal cost at the end of the project which includes all the cash flows on liquidation. The table of incremental cash flows is given in the appendices. NPV, IRR and PI Alternative 1 Alternative 2 NPV $ 2,60,512 $ 6,32,774 IRR 54% 82% PI 2.5 3.5 Based on the above incremental cash flow analysis, the company should opt for alternative 2 as it has higher NPV. A project with positive NPV is acceptable and higher the NPV the better it is. Also if the IRR is more than the required rate of return, the project is acceptable. A profitability index of more than 1 is acceptable. Since both the projects have positive results but since alternative 2 has higher NPV, IRR and PI the company should opt for replacing the old machine with a new one. NPV and IRR profile NPV profile is the graphical representation of NPV at different required rates of return. The below graph represents the NPV profile for both the alternatives at given required rates of return: From the above table we see that alternative 2 has a better NPV at all levels of required rates of return. The alternative 2 NPV line lies above the 1st alternative throughout. Hence we can say that there is no conflict in ranking between NPV and IRR because at all levels of IRR, alternative 2 only has better NPV and hence is preferred. Impact of Inflation Due to an inflation of 3.5% p.a, there is an increase in the operating and maintenance costs, advertising and marketing costs and overhead costs. Due to an increase in the above costs, there would be change in incremental operating net cash flows for both the alternatives. The cash flows will reduce. Due to a decrease in net operating cash flows, the NPV, IRR and PI will decrease for both the alternatives. The new operating incremental cash flows and capital budgeting techniques are given in appendices. The change in NPV, IRR and PI is presented in the table below: Alternative 1 Alternative 2 Before Inflation After Inflation Before Inflation After Inflation NPV $ 2,60,512 $ 2,22,359 $ 6,32,774 $ 5,96,510 IRR 54% 48% 82% 78% PI 2.5 2.3 3.5 3.3 Base Case Scenario The base case here would be the expected profits of the company for the next five years which is $130000 in the first year and a 2.9% increase every year. The base case scenario does not apply to alternative 1 because the total net income for the project is $627,842 whereas the total expected profits are $688,809. Since the base case profits are more than project 1 profits, hence the scenario does not apply. For alternative 2, the sales and operating and maintenance costs have been altered to make the project just feasible for the company. The changes are presented in the table below: Sales Operating and maintenance costs % change Decrease by 18.24% Increase by 167% Total Net Profit $688797 $688815 NPV $283282 $269184 IRR 47% 44% PI 2.1 2.1 From the above table we see that sales were reduced by 18% to bring the project to being just feasible. This reduced the NPV, IRR and PI of the project. Even though the above items have reduced but the project is still feasible to the company because the NPV is positive, IRR is more than required rate of return and PI is more than 1. There is a huge change in operating and maintenance costs. The costs were increased by 167% to make the project just feasible for the company. This means that this cost is low as compared to other costs. Leasing Decision Lease can be either Operating lease or a Financial Lease. Under operational lease, the ownership of the asset is never transferred to the lessee whereas under financial lease the ownership of the asset is transferred at the end of lease term. Leasing is advantageous in term of tax savings. Lease rental is tax deductible, so is the depreciation. Since ownership rights are not available with the company, it is not advisable to go for lease as for tax savings depreciation is available and purchase of asset increases the companys assets. The operating lease is for a short term and hence for a project 5 years if operation, the lease would have to be renewed which is expensive and time consuming. Operating lease is considered an expense for the company whereas finance lease is considered a liability. An increased liability affects the credibility of the company in terms of acquiring a loan; hence the same is not advisable. Moreover, Lifestyle furniture is a profit making company and hence should use its earnings for purchase of asset rather than opting for a lease. WACC The weighted average costs of capital have been calculated using the book value and market value weights. The WACC is presented below: Book Value Market Value Source of Capital costs Book Value Weights Cost of capital Market Value Weights Cost of capital Long term debt 6% 4000000 0.784 0.032 3840000 0.55 0.02 preference share capital 13% 40000 0.007 0.001 60000 0.008 0.001 ordinary share equity 17% 1060000 0.207 0.035 3000000 0.434 0.073 Total 5100000 6.9% 6900000 9.8% The WACC is higher for market value weights of the different source of capital. This is because the cost of equity is the highest and the market value weights of equity is higher as compared to book value weight, thus a high weighted cost of equity has led to an overall increase in WACC. The preference share capital hardly has any effect on the WACC. Conclusion/ Recommendation On the basis of the above analysis, it is clear that the company should opt for alternative 2 of replacing the old machine with the new one. This is because the proposal has a higher NPV, IRR and PI. Also one of the main reasons is that alternative 1 of renewing the existing machine does not satisfy the base case scenario of the company of the minimum profits the company is expecting in the next five years. The total profits are lower than the expected profits. Whereas alternative 2 will be able to generate more than the total expected profits of the firm. Hence, the company should go ahead with replacing the old machine with a new one. Appendices Incremental Cash Flows NPV and IRR Profile Impact of Inflation Base case Scenario