Introduction
Companies usually make investments in order to derive a return on the investment. There are investment projects that are good or bad depending on whether they add any financial value to the company. Therefore, there are various capital budgeting techniques that are used to evaluate the financial soundness of an investment project in order to ascertain whether the project should be accepted or rejected. This paper seeks to evaluate ABC Company new inventory management system to ascertain whether it is a good investment or a bad one using various capital budgeting tools.
Payback period evaluates investment projects basing of the duration needed to recuperate the investment initial cost outlay based on the projected cash inflows. It is computed by dividing the initial outlay with the annual net cash flows in the annual cash inflows are the same. However, in case they are different then it will be given by the formula below;
PBP = Years before full recovery + Remaining Cash flow/ Cash flow in year of full recovery
Payback Period = 3 years + (200,000 – 174,600)/101,000 = 3.25 years
Normally, projects with a lesser payback period should be accepted. In case of a single project, projects with a payback period that is less than the benchmark payback period of the entity should be accepted. In this case, a benchmark payback period was not given. However, the investment is a good investment. This is because the payback period is only 3.25 years yet the investment will generate cash flows for 6 years. Therefore, the company will generate cash flows long after it has recouped its initial investment if it undertakes the project.
Return on Investment
Return on Investment (ROI) is an investment measure that is used to evaluate the efficiency of a project basing on its undiscounted cash inflows. Return on investment is computed by dividing the difference of the total net cash inflows and the cost of investment by the cost of investment. ROI is usually expressed as a percentage.
Total net cash inflow = 45,000 + 58,600 + 71,000 + 101,000 + 105,000 +104,000 = 484,600
Initial investment = 200,000
Therefore;
ROI = {(486,400 – 200,000)/200,000}*100% = 142.3%
The new inventory system by ABC Company is a good investment. This is because it has a return of over 100 per cent. A return of over 100 per cent implies that the company will make a net return that is greater the initial investment of the project.
Net Present Value
Net Present Value (NPV) evaluates investment projects basing on the net discounted cash flows. NPV is computed by subtracting the investment initial outlay from the total discounted cash inflows. The investment criteria basing on net present value is to accept projects with a positive NPV and reject projects with a negative NPV. When evaluating various projects, the project with the highest value should be selected.
The NPV of the implementing the new inventory system is positive. Therefore, the investment is a good investment. ABC Company should go ahead with the investment. An investment with a positive NPV will increase the net worth of a company. Therefore, by investing in the new inventory system ABC Company will increase its net worth.
Conclusion
Basing on the payback period, return on investment and net present value, ABC new inventory management system is a good investment. The investment will increase the net worth of the company and shareholder’s wealth.
References
Gibson, C. (2010). Financial Reporting and Analysis: Using Financial Accounting Information. New York: Cengage Learning.
Prasanna, C. (2011). Financial Management. New York: Tata McGraw-Hill Education.
