Equipment by Clarks Paints
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The decision to be considered for the proposed equipment purchase by Clarks Paints is capital budgeting decision. Capital budgeting is the long-run planning for proposed investment projects. The life of a project is usually longer than one year, so capital budgeting decisions considers cash inflows and outflows over long periods. In evaluating the proposed equipment purchase for Clark Paints two main discounted cash flow (DCF) methods were used to measure all expected future cash inflows and out-flows of the project discounted back to the present period, i.e. the Net Present value method (NPV) and the Internal rate of return method (IRR). The payback method and the accounting rate of return (ARR) were also used to evaluate the proposal.
The payback method measures the time it takes to recoup, in the forms of cash inflows, the total cash amount invested in a project. The payback method neglects both cash flows after the payback period and the time value of money. The payback period determined to be 3.43 years for the proposed project. The project appears to have a short payback period indicating that it is highly liquid. All else being equal, the shorter the payback period the more attractive the asset, hence the r recommendation is acceptance of the project.
The accounting rate of return (ARR) method divides an accrual accounting measure of average annual income from a project by an accrual accounting measure of its investment. ARR considers profitability but does not consider the time value of money. The ARR calculated for the project was 29.18% per year. This indicated that every dollar of investment generates 29.18% of after -tax operating income. The higher the ARR the better project is considered to be, hence based on this method the recommendation is acceptance of the project.
DCF is considered to be the best approach to capital budgeting. The NPV method is the preferred DCF method. The NPV method calculated the expected net monetary gain from the project by discounting all expected future cash inflows and outflows, using the required rate of return which was determined to by 12% for Clarks Paints. Based on the computations performed the project yield a positive NPV of $33,035. A project is acceptable in financial terms if it has a positive NPV. Hence based on this positive NPV the recommendation is acceptance of the proposal.
The IRR method computes the rate of return (also called the discount rate) at which the present value of expected cash inflows from the project equals the present value of expected cash outflows from the project. A project is acceptable in financial terms if its IRR exceeds the required rate of return. As mentioned above 12% discount factor the project yielded a positive NPV. Using a higher discount factor of 18% the project yielded a negative NPV of ($56). Hence the IRR is taken to be approximately 18%. A project is