Brief Report To The Board Of Grsh Company
Capital budgeting techniques helps the investor to make and effective and efficient decision as to decide whether to invest in the particular option or not. There are various capital budgeting techniques like Net Present Value, Internal Rate of Return, payback period, Discounted Payback period and etc. Each of the capital budgeting technique has different decisive factor. In the given case, three techniques have been applied namely – NPV, IRR and Payback period. Two options are available for the company – buying and leasing. From the calculations of the NPV, IRR and Payback period of each of the options, following are the comparison made on the basis of the results achieved.
- On the basis of the NPV techniques: NPV is defined as the excess of the present value of cash inflows over the present value of cash outflows. If the NOV comes out as positive being greater than zero than the proposed investment plan is selected (Illes, 2012). In the first option of buying, NPV has been calculated as $832101 and in the second option NPV has been calculated as $1023736. The major reason for higher NPV is that the second option does not have the heavy initial outlay and this is its major strength as compared to first option in which $1600000 have been spent in lump sum (Blas, 2016 and Edwards, 2010) .
- On the basis of the IRR technique: IRR is defined as the rate at which the present value of cash inflows equals to the present value of cash outflows. If the internal rate of return is more than the cost of capital then the proposed investment is selected otherwise it is rejected. In the first option of buying, IRR has been calculated as 23.16% and in the second option of leasing, IRR has been calculated as 34.33%. IRR has been higher in the second option because of the higher cash inflows over the cash outflows (Cristodoulou, 2016).
- On the basis of the Payback period technique: Payback period is defined as the period in years within which the outlay can be set off from the proposed cash inflows. Its decisive factor depends on the time taken to repay back the initial investment. Shorter the time more will be the chances of getting the proposal selected otherwise the proposed investment will be rejected. In the first option of buying, Payback period has been calculated as 4.47 years and in the second option of leasing payback period is 3.48 years. The major decrease in the payback period is due to the decrease in the cash outflows which will help the company in repaying the amount at the earliest.
From the above analysis:
- Option of leasing have high NPV
- Option of leasing have high IRR
- Option of leasing has less payback period.
As per the given data, company normally wants to invest only in that project which have payback period of less than 3years and also wants to go for that proposal only which help on meeting their hurdle rate of return on 25%. As per the analysis made the option of leasing have IRR higher than hurdle rate of 25% and have payback period of 3.48 years. Though meeting out all the criteria set by the company, the second option payback period is leaving at 3.48 years but lesser than option of busing of 4.47 years.
Therefore, Option of leasing has been selected for the investment.
Blas B, 2016, “Net Present Value”, available from
https://www.uam.es/personal_pdi/economicas/bdeblas/teaching/ucd/ecn134/lectures/slides1.pdf accessed on 07/06/2017
Cristodoulou A 2016, “The Internal Rate of Return Problems and Manners of Solution”, available from https://www.iamb.it/share/img_new_medit_articoli/802_32cristodoulou.pdf accessed on 07/06/2017.
Edwards G, 2010, “Comparing NPV and IRR”, available from https://www.brighthubpm.com/project-planning/95800-comparing-npv-and-irr/ accessed on 07-06-2017.
Illes M., 2012, “Links between Net Present Value and Shareholder Value from a Business Economic Perspective”, available from https://www.academia.edu/3628065/Links_Between_Net_Present_Value_and_Shareholder_Value_from_a_Business_Economics_Perspective accessed on 07-06-2017.