Project 1 (Table 1 on page 462, n=1-4, r=16%)
Yr 1 $144,000 * 0.862069 = $124,138
Yr 2 $147,000 * 0.743163 = $109,245
Yr 3 $160,000 * 0.640658 = $102,505
Yr 4 $178,000 * 0.552291 = $98,308
PV of inflow of cash $434,196
Cost of Investment (400,000)
NPV $34,196
Project 2 (Table 1 on page 462, n=1-4, r=16%)
Yr 1 $204,000 * 0.862069 = $175,862
Yr 2 $199,000 * 0.743163 = $147,889
Yr 3 $114,000 * 0.640658 = $73,035
Yr 4 $112,000 * 0.552291 = $61,857
PV of inflow of cash $458,643
Cost of Investment (400,000)
NPV $58,643
Since the NPV of Project 2 is greater than that of Project 1, Advo should adopt the Project 2.
One of the basic theories in financial management is “time value of money”; which states that the money which one has now has greater value as compared to the promise of receiving the similar amount on some date in the future. So, a dollar has more worth today as compared to the same dollar in the future. This means that if that dollar is invested today, it would earn a better return on investment. The time value of money is used to help people identify and compare the value of its future payments. In simple words, the expression states that with the passage of time, the value of the money decreases as does the purchasing power associated with that money (Fabozzi and Mann, 2010). This theory is highly significant as it helps in calculating the present value as well as the future value of that money.
When an investment is made, the money is actually exchanged for a promise that in the future. It is through the time value of money that allows the investors to calculate the value of that future money today so that the investor can decide if this project is worth investing in or not. It is important to find the present value of all the future payments and then the Net Present Value is compared with the invested value. If the NPV is positive it means that the return would exceed the invested money and so the project should be chosen as suitable for investment but in case, the NPV is negative then that project should be straightly rejected as there would be no return on the investment. A dollar has different value in different period and time value of money is important when capital investment decisions are to be made (Edmunds and Tsay et al., 2011).
It is not only the financial factors, but the managers also require taking into consideration certain non-financial factors when deciding about a meaningful investment to be made. The truth is that most of these non-financial factors are more critical than the financial ones including: how does the investment affect the level of motivation of the staff; backend sales which the company shall receive due to investment in a non-profitable project; level of satisfaction of the customers due to this investment; sufficiency of human resource to match the required manpower; how the competitors would react; government regulations; prevailing trend to known the potential of the project; affect on the climate to remain socially responsible as a corporation (Besley and Brigham, 2008). All these issues and particularly the issue of green environment was not important two to three decades ago; but now, with rise in the level of uncertainty and the increasing awareness of the consumers, the non-financial factors have gained a lot of significance while making an investment decision.
Capital investment decisions involve making plans, setting goals, finance arrangement and selecting long-term assets. This is also known as Capital Budgeting; in large companies, this decision is made by higher level of management which gains approval from the board of directors. The appropriate level of management needs to approve formally until the money is spent. Some companies may allow the plant manager certain amount of project decisions which when exceeded would have to be taken for approval to the division manager; and if the capital investment decision is being made of a significant amount, then the board would have to be involved. The capital budgeting is highly critical decision because it tends to create accountability and measurability (Edmunds and Tsay et al., 2011).
As compared to other business decisions, the capital investment decisions require two important aspects to be decided: financial and investment. When a project is taken, a financial commitment is made which has its own risks. Additionally, an investment is being made by the business which shall influence all the future decision of the company (Thomas and Mock, 2004). Further, decision for capital investment is relatively large as compared to the daily decisions and also the elapse of time is greater between the investment and the return.
References
Besley, S. and Brigham, E. (2008). Essentials of Managerial Finance. 14th ed. OH: Thomson Higher Education.
Edmunds, T., Tsay, B. and Olds, P. (2011). Fundamental Managerial Accounting Concepts. 6th ed. New york: McGraw-Hill Irwin.
Fabozzi, F. and Mann, S. (2010). Time Value of Money. Introduction to Fixed Income Analytics: Relative Value Analysis, Risk Measures, and Valuation, Second Edition, pp. 1--32.
Thomas, M. and Mock, E. (2004). CAPITAL INVESTMENT DECISIONS. Essentials of Physician Practice Management, 6 p. 100.
