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Based on the above incremental cash flow analysis, the company should opt for alternative 2 as it has higher NPV. A project with positive NPV is acceptable and higher the NPV the better it is. Also if the IRR is more than the required rate of return, the project is acceptable. A profitability index of more than 1 is acceptable. Since both the projects have positive results but since alternative 2 has higher NPV, IRR and PI the company should opt for replacing the old machine with a new one.
NPV and IRR profile
NPV profile is the graphical representation of NPV at different required rates of return. The below graph represents the NPV profile for both the alternatives at given required rates of return:
From the above table we see that alternative 2 has a better NPV at all levels of required rates of return. The alternative 2 NPV line lies above the 1st alternative throughout. Hence we can say that there is no conflict in ranking between NPV and IRR because at all levels of IRR, alternative 2 only has better NPV and hence is preferred.
Impact of Inflation
Due to an inflation of 3.5% p.a, there is an increase in the operating and maintenance costs, advertising and marketing costs and overhead costs. Due to an increase in the above costs, there would be change in incremental operating net cash flows for both the alternatives. The cash flows will reduce. Due to a decrease in net operating cash flows, the NPV, IRR and PI will decrease for both the alternatives. The new operating incremental cash flows and capital budgeting techniques are given in appendices. The change in NPV, IRR and PI is presented in the table below:
Base Case Scenario
The base case here would be the expected profits of the company for the next five years which is $130000 in the first year and a 2.9% increase every year.
The base case scenario does not apply to alternative 1 because the total net income for the project is $627,842 whereas the total expected profits are $688,809. Since the base case profits are more than project 1 profits, hence the scenario does not apply.
For alternative 2, the sales and operating and maintenance costs have been altered to make the project just feasible for the company. The changes are presented in the table below:
Operating and maintenance costs
Decrease by 18.24%
Increase by 167%
Total Net Profit
From the above table we see that sales were reduced by 18% to bring the project to being just feasible. This reduced the NPV, IRR and PI of the project. Even though the above items have reduced but the project is still feasible to the company because the NPV is positive, IRR is more than required rate of return and PI is more than 1.
There is a huge change in operating and maintenance costs. The costs were increased by 167% to make the project just feasible for the company. This means that this cost is low as compared to other costs.
Lease can be either Operating lease or a Financial Lease. Under operational lease, the ownership of the asset is never transferred to the lessee whereas under financial lease the ownership of the asset is transferred at the end of lease term. Leasing is advantageous in term of tax savings. Lease rental is tax deductible, so is the depreciation. Since ownership rights are not available with the company, it is not advisable to go for lease as for tax savings depreciation is available and purchase of asset increases the company’s assets. The operating lease is for a short term and hence for a project 5 years if operation, the lease would have to be renewed which is expensive and time consuming. Operating lease is considered an expense for the company whereas finance lease is considered a liability. An increased liability affects the credibility of the company in terms of acquiring a loan; hence the same is not advisable. Moreover, Lifestyle furniture is a profit making company and hence should use its earnings for purchase of asset rather than opting for a lease.
The weighted average costs of capital have been calculated using the book value and market value weights. The WACC is presented below:
Source of Capital
Cost of capital
Long term debt
preference share capital
ordinary share equity
The WACC is higher for market value weights of the different source of capital. This is because the cost of equity is the highest and the market value weights of equity is higher as compared to book value weight, thus a high weighted cost of equity has led to an overall increase in WACC. The preference share capital hardly has any effect on the WACC.
On the basis of the above analysis, it is clear that the company should opt for alternative 2 of replacing the old machine with the new one. This is because the proposal has a higher NPV, IRR and PI. Also one of the main reasons is that alternative 1 of renewing the existing machine does not satisfy the base case scenario of the company of the minimum profits the company is expecting in the next five years. The total profits are lower than the expected profits. Whereas alternative 2 will be able to generate more than the total expected profits of the firm. Hence, the company should go ahead with replacing the old machine with a new one.
Incremental Cash Flows
Base case Scenario
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