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The CarCare Garage is considering an investment in a new tune-up computer. The cost of the computer is $48,000. A cost analyst has calculated the discounted present value of the expected cash flows from the computer to be $52,650, based on the firm’s cost of capital of 12%. What is the expected return on investment of the machine, relative to 12%? Explain your answer. The payback period of the investment in the machine is expected to be 4.25 years. How much weight should this measurement carry in the decision about whether or not to invest in the machine? Explain your answer.
How do non-time-value-of-money measures like payback period compare with time-value-of-money measures like NPV & IRR in decision making regarding capital projects?
Also, if there was a considerable degree of risk as to the likely future cash flows (such as because of competition hurting future sales volume) should the firm consider using a different discount factor than its historical 12% cost of capital? Why or why not?
Expert Answer
| Net Present Value | ||||||||||||||
| Present value of Expected cash Inflow at 12% | 52,650 | |||||||||||||
| Less: Initial Outflow | 48,000 | |||||||||||||
| Net Present Value | 4,650 | |||||||||||||
| It is one of the technique to know that at desired rate of interest is it viable to start the project | ||||||||||||||
| If NPV>0, then project is viable should be accepted otherwise reject the project. | ||||||||||||||
| Expected Returnon investment is calculated using return or gain which is | ||||||||||||||
| (sum of discounted cash flows – Intial investment)/Intial Investment =(52650-48000)/48000 | 9.69% | |||||||||||||
| The payback period is the number of years it takes to recover an initial investment. | ||||||||||||||
| The payback approach to investment selection has three serious shortcomings. | ||||||||||||||
| (1) payback calculation ignores the time value of money | ||||||||||||||
| (2) payback calculation ignores the profits and residual value that would be received beyond the maximum payback period | ||||||||||||||
| (3) the maximum acceptable payback period is set by the firm in a rather arbitrary manner without rigorous economic justification | ||||||||||||||
| Based on the above demerits in Non-time value of money like pay back period time value money like discounted cash flow more scientific and logical | ||||||||||||||
| If there is higher risk in future than the rate of discount should be higher than 12% so that proper care of such risk can be taken care of. | ||||||||||||||
