A critical appraisal of the results of the capital investment appraisal of the O

Question

A critical appraisal of the results of the capital investment appraisal of the Oracle and Clairvoyant (Document 6) with particular emphasis on the following areas:
a. A discussion of the reasons for the apparent conflicts between the investment advice provided by each method (375-425 words);
b. A discussion of the risk and return presented by each option and a recommendation as to which option should be chosen (170-200 words).

Document 6- Capital investment appraisal The Maintenance department is considering investing in a new piece of problem diagnostic equipment that will help them identify problems with production equipment more quickly reduce equipment down times and wasted material and components in the factory There are two options for the new piece of equipment: the Oracle and the Clairvoyant. The following information about the cash flows, profits and capital investment appraisal measures has been provided to you. The company's cost of capital is currently 6% Oracle Cumulative PresentDepreciation profit (E) cash flow Cash flow 6% Factors Year value (E) (1,500,000) 1.0000 (1,500,000) (1,500,000) 480,000 0.9434 420,000 0.8900 375,000 0.8396 315,000 0.7921 270,000 0.747.3 180,000 0.7473 452,832 (264,000) 216,000 (1,020,000) 373,800 (264,000) 156,000 (600,000) 314,850 (264,000) 111,000 (225,000) 249,512 (264,000) 51,000 201,771 (264,000) 6,000 360,000 134,514 227,279 2 4 90,000 540,000 540,000 Payback period Accounting rate of return Internal rate of return 3 years 9 months 12.86% 11.31% Clairvoyant Cumulative Present Depreciation Profit (E) cash flow Cash flow Year Factors value (E) (2,000,000) 1.0000 (2,000,000) (2,000,000) 370,000 0.9434 431.000 0.8900 513.000 0.8396 575,000 0.7921 657.000 0.7473 246.000 0.7473 NPV- 349,058(350,800) 19,200 (1,630,000) 383,590 (350,800) 80,200 (1,199,000) 430,715 (350,800) 162,200 (686,000) 455,458 (350,800) 224,200 111,000) 490,976 183,836 293,632 2 4 (350,800) 306,200 546,000 792,000 792,000 Payback period Accounting rate of return Internal rate of return 4 years 3 months 14-11% 10.29%

Explanation / Answer

The conflicts between the investment advice:

Firstly if we consider the methodology used for capital budgeting over here we can notice that we have considered a Net present value approach, an Internal rate of return, and Payback period. All the methods are considered with a cost of capital to the company at 6% respectively. The conflict arises as we are using straight-line depreciation for the equipment it is better to use an Accelerated depreciation approach as the company can be in the higher tax bracket, and depreciation cannot be taxed and can be added back to net income, therefore going for Accelerated depreciation is idle for Company. Secondly, when there is a decision on capital budgeting need to be taken always consider NPV over IRR, as there are set of limitations for IRR over NPV. It is a golden rule in Finance that opting for NPV over IRR, Whereas payback period goes if the gross income (Cashflow) increases then Payback period will decrease, and we are predicting the cash flow and there no certainty on what the amount can be, therefore it is not idle to alone stick to payback period at any means.

B) Now considering Risk and return, for option 1 investment is 1,500,000, return is 5,40,000 that is 36% return and for option 2 investment is 2,000,000 and profit is 792,000 return is 39.6%. Now considering the risk over here in option 1 we had cashflow being decreasing in nature from year 1 to year 5. Therefore it is drafted at the conservative approach on the other hand in option 2 the cash flows were increasing from year to year which is the optimistic approach. Now I would select option 1 (Oracle) as the risk associated with a return is better and approach used is conservative.

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