Investment Decision
Investment Decision
Cost of New Plant $1,500,000
Cost of Inventory and Receivable 200,000
Total Cost of Investment (Initial Outflow) $1,700,000
8-Year Incremental Cash Flow
Payback-Period and Net Present Value
Payback Period = 3 + (-158,125 / 579,500) = 3.27 years
Analysis and Recommendation
Incremental cash flow is a helpful tool that helps the management in making decision whether to pursue potential investment or, in case of various plans, to choose which of those plans are to be prioritized. Apparently, the manufacturing company has an option to make product expansion by launching new item. The firm needs to invest an initial cost of $1,700,000 to pursue the launching.
Based on the computation presented above, launching new product and acquiring new plant is advantageous for the firm. The projected new present value of the initial investment will give the manufacturing company a total of $ 1,144,007 additional earnings after eight years of operation. The total amount of expected inflow is higher than the required outflow. In addition, the forecasted payback period, or the length of years that the firm needs to wait to recover the total investment cost is only 3.27 years. It means that after 3.27 years, the product expansion is expected to start bringing net earnings for the company.
Therefore, given the huge amount of potential earnings that the firm could generate from the product expansion and the relatively short period needed to recover the initial investment, purchase of the additional plant is highly recommended.
Effect of Existing Company Policy
Based on the computation, the projected payback period is 3.27 years, which exceeds the current company policy of rejecting projects that has a payback period longer than 3 years. Having such policy signifies the current basis of investment decision that the firm observes. However, the payback period should not be the sole basis to be considered. Payback period only measures the length of time the project will recover the initial costs without considering the potential income after the recovering period. Thus, it is advisable that the company assesses the net present value of the investment and uses it as the basis of decision rather than highlighting the waiting period.
Effect of Additional Cost Requirement
Based on the computation of the net present value, the proposed expansion is very advantageous for the firm. The projected earnings are higher than the required initial cost. Thus, an acceptable recommendation was made.
However, additional cost requirement other than mentioned above would have an effect on the recommended decision. Any additional cost that will result in a positive net present value will still be tolerable. For example, if the additional cost will amount to $ 1,000,000 or below, the firm can still expect a NPV of $144,007 or above, thus, making the project still acceptable. On the contrary, of the additional cost will total to $1,144,0007 and above, the resulting NPV will be zero, and worst, in negative value, then the proposed project should be rejected based on two reasons. First, zero or negative NPV means that the firm will not generate benefits from making the investment. Thus, it is not wise to pursue the purchase. Second, given the company policy of rejecting projects that has a payback period exceeding 3 years, and the proposed project has a tendency of bringing loss to the firm, allocating funds to a negative earning investment is not an option to consider.
