Net present value (NPV) refers to the change in a business's net worth due to a specific investment. The net present value is calculated as the current value of the difference between cash inflows and cash outflows. The net cash flows' present value is calculated at a discount rate, which is mainly equal to the investors' expected return rate after considering the potential risks. The cash inflows expected from installing an additional CNC machine are at least $50,000 more in sales per month. Annually, the increase in sales equal to $600,000. The salvage value is a cash inflow as it represents earnings from the sale of the CNC machine after 5 years. The cash outflow refers to all expenses resulting from the additional CNC machine. The margins on the additional sales are projected at 35%, meaning that the forecasted costs of goods would be 65% of the revenue. The resulting operating costs are forecasted at $10,000 per month hence $120,000 per annum.
Option 1 involves the purchase of a CNC machine using cash. The cash outflows include the machine's cost, $142,000, the annual operating costs of $ 120,000, and the costs of goods sold, 65% of sales revenue. The cash inflows include $600,000 annual sales and a salvage value of $40,000 at the end of year 5. At a discounted rate of 7%, the net present value for option 1 is $322,932. Option 2 involves a hire purchase of a CNC machine at a $50,000 down payment and monthly installments of $2,200. The other cash outflows are costs of goods sold at 65%, operating costs of $120,000, and a $1 payment at the end of year 5. The cash inflows are the same as option 1, $600,000 in sales revenue. At a discounted rate of 7%, the net present value for option 2 is $283,077.
Delegate your assignment to our experts and they will do the rest.
A positive NPV implies that investment would be profitable because the discounted costs are lower than cash inflows' present value. On the contrary, a negative NPV means that an investment would be unprofitable because the discounted value of cash outflows are more than the discounted future cash inflows. The higher the NPV, the more profitable an investment is because it means that the current value of projected cash inflows is far above the current value of the projected cash outflows (Juhász, 2011). The NPV for both option 1, $322,932, and option 2, $283,077, is positive, implying that the two investments would be profitable. Since the NPV for option 1 is higher, option 1 would be more profitable than option 2.
The payback period estimates the time that an investment requires to become profitable. An investment becomes profitable after the net cash flow becomes positive. A shorter payback period implies that a business generates cash inflows after a short period and is, therefore, preferable ( Ardalan, 2012). The payback period for option 1 is 1.58 years. This means that the cash inflows would exceed the cash outflows after 1.58 years. On the other hand, the payback period in option two is 0 years because the net cash inflows in the first year are positive. Based on the payback period, option 2 financing is preferable as compared to option 1.
The net present value is more effective in evaluating an investment relative to the payback period. The net present value considers the entire cash flow stream while considering the time value of money (Ardalan, 2012). However, the NPV relies on assumptions about the discount rate and does not consider all the investment benefits (Juhász, 2011). The payback period is a simple method of analyzing the time after which a project's costs would be recovered and does not consider the time value of money and cash flow after the breakeven point (Ardalan, 2012). Therefore, although option 2 has a shorter payback period, the higher net present value suggests that option 1 would be preferable. Peregrine should therefore consider cash budgeting and planning to avail cash for the purchase of the CNC machine.
References
Juhász, L. (2011). Net present value versus internal rate of return. Economics & Sociology, 4(1), 46-53.
Ardalan, K. (2012). Payback period and NPV: their different cash flows. Journal of economics and finance education, 11(2), 10-16.
