Capital Investment Decisions – Annual Worth, Present Worth And IRR

Introduction to Capital Investment Decisions

1. Explain how Annual worth, Present worth and Internal Rate of Return (IRR) are used in capital investment decisions.

2. What are the conventional and modified Benefit to Cost ratios and how these are used in capital investment decisions. Check in your workplace where equipment can be replaced by alternative brand with different price to buy and/ or different salvage value/ resale value/ disposal cost at the end of life, might have different cost to operate due to different energy rating, power consumption, spare parts etc. and different capacity/ production rate and/ or quality resulting different price of products from alternative options.

3. Develop the Annual After-tax Cash Flow (ATCF’s) for the leasing alternative. If the Minimum Attractive Rate of Return (MARR) after taxes is 10%, what is the equivelant annual cost for the leasing alternative?

4. Using a MARR of 10% and a before-tax analysis, determine the preferred course of action.

5. Prepare a report/technical paper starting from report/ technical paper.

In the process, of capital budgeting decisions to be conducted by the company, the concepts of present worth, internal rate of return and the annual worth hold special significance:

1. Present Worth-

It is of utmost importance that the revenue or the cash flow that is going to be accruing in respect of the company from the project should be discounted using a suitable discounting rate. The reason behind this is that the cash flows that are expected to arise from the project are needed to be adjusted for the fluctuating inflation rate of the economy, the return that is expected by the stakeholders in return of the risk undertaken by them and several other factors. Calculation of the present worth of the inflows gives out the real value that is going to accrue in favour of the company at the end of the project.

1. Internal rate of return-

The percentage of the real return that is generated by the project in respect of the company is demonstrated by the internal rate of return. The internal rate of return generated by the project must always be above the cost of capital of the project. The cost of capital is termed as the amount that the company will have to pay the investors in terms of the interest and the repayment of the amount invested by the third parties (Baum et al., 2017). It might be possible that the net present value of a project is positive but the internal rate of return for the same is less than the cost of capital of the firm. In such a situation, the company will fail to repay the interest and the principle amount to the third parties from whom the company has taken the loan.

1. Annual worth-

Importance of Annual Worth, Present Worth, and IRR in Capital Investment Decisions

The annual worth represents the amount that is generated by the project annually. This information is very crucial in respect of the capital budgeting analysis to be conducted by the company in respect of the project. This is because of the fact that using this information the company will be able to ascertain the number of years it will take to get the entire investment back from the project in the form of cash flows.

The Annual worth of alternative C is the highest and Alternative A is the lowest.

The present value of alternative C is the highest and the present value of alternative D is the lowest.

The IRR of alternative B is the highest. The lowest IRR is of the alternative D.

The numerator and the denominator in case of conventional benefit cost ratio, contains the net benefit that has arisen from the project and the cost that has been incurred by the entity for the project respectively. In case of modified benefit cost ratio the operating costs of the project and the maintenance cost of the project are being deducted from the net benefits that has arisen for the users of the analysis. Due to this, the net revenue generated by the company is received in the numerator and the denominator represents only the initial cost that has been incurred in respect of commissioning of the project.

The recommendation or the result that is obtained regarding the acceptability of the project is always same in case of both the formulas irrespective of the changes that the formulas of the method carry. For the same project under consideration, the value given out by both the formulas will be either above one or below one simultaneously (Crosby & Henneberry, 2016).

For conducting the cost benefit analysis these methods are used in the capital budgeting processes. If the answer given out by the method is greater than one then the project is to be accepted and if the answer given out is, less than one then the project will have to be discarded by the entity. The reason being that in the numerator, the revenue of the project is carried and in the denominator the expense or the outflows of the project is represented. If the revenues of the project is more than the expense of the project the result will be more than one and if the expense are more than the revenue generated by the project then the result will be less than one.

Conventional and Modified Benefit-to-Cost Ratios

Modified B/C Ratio value using Present worth benefit

The table above indicates the Equivalent Annual cost of different alternative options. It can be seen that the equivalent annual cost of replacing x with Z is low so this option should be selected.

 The company under consideration is the Australian telecommunication giant Vodafone Hutchison Australia. The company is concerned with the provision of the telecommunication and broadband services to the mass of the country. The company is currently conducting its operations in around 26 countries and hence the requirement of maintaining its operations is immense.

The present report is focussed on explaining the relevance of life cycle costing as a tool and the way its integration in the operation of the entity ensures that value is created for the stakeholders of the company, as the management of the company is able to manage the costs of the company more effectively and efficient     lee. The various gaps that have been found in the implementation of the same in the operations of the Vodafone Company will be discussed in detail. It is very crucial to understand the gaps that are present in the implementation process of this system. It is necessary because only after developing an understanding regarding the gaps present in the system it will be possible to alleviate the same (Idowu et al., 2016). Subsequently, some recommendation will be made to the management concerning the due consideration that must be given by it to the cost implications of the decisions taken by it in respect of the operations of the entity.

It is very difficult to completely eradicate the gaps that are presented due to the implementation or usage if any accounting toll or management tool by the company for monitoring its procedures. The gaps and the inefficiencies of the systems are the result of the carious feature and the characteristics that may be and may not be same for the operations of the Vodafone Company. The gaps present in the implementation procedures of the tools should not at any cost refrain the company from making use of such a good tool. Instead, the company must endeavour to look for ways for alleviating the gaps that are present within the system with respect to the application of the tool. The main purpose of identification of the gaps in the process is not to determine whether the tool is useful for the management or not. Rather the main purpose is to find out ways in which the gaps present in the system can be alleviated. Some of the gaps that have bene discovered in the application of the life cycle costing process of the company are as follows:

1. Nominal yield rates must be adopted by the company for determining the nominal cash flows arising in respect of the company. For making use of the actual rates by the company, it must be ensured that the cash flows generated or accruing in respect of the company must be adjusted for the variations in the price level index. The effects of the annual fluctuating inflation rates must also be factored in by the management.
2. There are significant amount of systematic risks that are being incurred by the fund providers the same must be adjusted against the costs. This is done because the investors investing their money in the project FO the company also demand certain justifiable and good returns out of the investment that is being made by them.
3. The market value of the wider angel of the financial sources that are being used by the company must form the basis of the weights that are being chosen by the company for this purpose. The present accounting information available with the entity must be used if information pertaining to the market value FO the resources is not available due to some reasons with the company.
4. It is also observed that the discounting rate that is being used by the Vodafone Company is always subjected to change. Several factors affect the rates on a continuous basis. These factors may or may not be in the hands of the management. These factors include the capital structure of the company, the amount of systematic risk involved in the project, the changes that might occur in the inflation rate of the economy and the changes in the forecasted cash flows of the project.

The continuous monitoring of the cost incurred by the company in respect of its operations and the revenue generated by them is very crucial for ensuring that the company is able to generate significant amount of revenues on a sustainable basis. If the monitoring of the costs will not be conducted by the company then the process of revenue generation by the company will become so inefficient that the stakeholders will never be able to receive the returns they were expecting to get. Hence, it is of utmost importance that the company undertakes the maintenance and the upkeep of all the internal control systems and the control mechanism installed by the company must be monitored on a regular basis. Some of the recommendations that can be made to the management are as follows:

1. For the purpose of identification of the risks present in the environment of the Vodafone both externally and internally, the company must undertake the adoption of the policy of recruitment of the best financial advisors present in the market. The management must go through the papers that are big published by the firms and the companies providing the financial services to the entities all across the globe (Mulley et al., 2016).
2. The management must make sure that for the purpose of capital budgeting decision it must make use of such discounting rates that takes into account the variation in the inflation rates of the economy, the factors that affects the future cash flows of the company and elements that are present in the environment of the entity that can affect the company internally and externally.
3. The market values of the financial sources used by the company should form the basis of the weights to be used by the company.

Conclusion:

the revenue generated by the company and the future expected cash flows of the entity are greatly influenced by the cost implications of the decisions that are being taken up by the management. The management of the company also needs to factor in the returns that are going to be generated by the decisions that are going to be taken by the management in respect of the projects that are going to be taken up by the management. The company makes use of the various fixed assets acquired by it or hired by it for the generation of cash flows in the future. Therefore, all the decisions regarding the acquisition of such fixed assets form a significant part of the company’s future revenue generation capability. Therefore, for the purpose of decision making by the management of the company it is required that the right kind of tools are used. Management and accounting tools such as life cycle costing helps the management immensely in these decisions.

Reference

Baum, A., Mackmin, D., & Nunnington, N. (2017). The income approach to property valuation. Routledge.

Crosby, N., & Henneberry, J. (2016). Financialisation, the valuation of investment property and the urban built environment in the UK. Urban Studies, 53(7), 1424-1441.

Idowu, A. M., Kamarudin, N., Achu, K., & Solomon, I. A. (2016). A Review of Valuation Impact on Property Tax. Sains Humanika, 8(4-3).

Mulley, C., Ma, L., Clifton, G., Yen, B., & Burke, M. (2016). Residential property value impacts of proximity to transport infrastructure: An investigation of bus rapid transit and heavy rail networks in Brisbane, Australia. Journal of Transport Geography, 54, 41-52.

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