Recommendation
I would recommend the company to accept the proposal since it will add value to the firm. This is because the proposed project is viable as indicated by the calculated measures. The payback period for the project is 3.43 years. Payback period is the time a proposed investment takes to accumulated sufficient cash flows to recover the initial cost of the investment. In this case, the proposal will take 3.43 years to recoup the initial cost of $200,000. In the absence of a desired payback period, we can compare the proposal’s payback period with its useful life. The proposal’s payback period is less than its useful life hence the company will recover the initial cost before the end of the useful life.
The proposal’s annual rate of return is 13.18% implying that it generates an annual net income of $0.1318 for every dollar of the initial cost. The annual rate of return is positive indicating that the proposal is profitable hence accepting it will lead to an increase in the overall profitability of the company. Besides, 13.18% is a high rate of return hence the company should take the project. The above two techniques may not give the real picture of the project’s viability. The two measures ignore the time value of money hence a company can make an unsound capital budgeting decision if it relies on the two measures. Additional measures such as the NPV and IRR must be used to evaluate the proposal.
The proposal has a net present value of $47,194. This implies that the present value of the benefits or cash inflows outweighs the present value of the costs of the proposal. Under this technique, a project with a positive NPV is considered viable and increases the firm’s value if it is accepted. Projects with positive net present values enhance shareholders’ wealth maximization. According to Fisher’s Separation theory, so long as the project has a positive NPV the company will maximize shareholders’ wealth. The interests of other stakeholders will be automatically met. The NPV for the proposal is positive hence the company should accept it.
The IRR of the proposed investment is 23.60%. Internal rate of return is the rate that equates the present value of benefits and that of costs associated with the project. If the firm’s discount rate is equal to the internal rate of return, the net present value of the project will be zero. The project’s IRR is compared to the company’s discount rate to assess the viability of a proposed investment. The decision criterion, in this case, is to accept any project whose IRR is more than the company’s required rate of return. On the other hand, if a proposed investment’s IRR is less than the required rate of return, it is not viable hence it is rejected. The company’s required rate of return for new projects is 12%. It implies that the company cannot only finance a project if it generates a minimum rate of return of 12%. The proposal’s IRR is more than the firm’s. If accepted, the project will make more than the minimum requirement hence it is viable.
The above financial measures show that the proposal is viable. If the project does not affect non-financial factors such as customer satisfaction, employee motivation and does not contravene any regulation, it should be accepted.
