Investment Decisions (Cambridge (CIE) A Level Accounting): Revision Note

If you are asked to compare two projects, then give reasons for both before making your recommendation.

Non-financial factors are usually worth 2–4 marks. Give the factor and explain why it matters. Do not just list names.

The directors of V Limited are planning to expand their manufacturing capacity to meet rising demand. They are considering the purchase of one of two mutually exclusive machines: Machine Alpha or Machine Beta.

Both machines have an estimated useful life of four years and will have no residual value at the end of the project. The company uses a cost of capital of 10%.

The management accountant has already calculated the estimated net cash flows and the financial investment appraisal metrics for both options.

Estimated Net Cash Flows:

Investment Appraisal Results:

Additional Information:

1. Machine Alpha is manufactured locally by an existing supplier. It is very similar to the machines currently used by the factory workers.

2. Machine Beta is imported from an overseas supplier. It uses highly advanced, automated technology that produces a slightly higher quality finish, but it will require specialist overseas engineers to be flown in if major repairs are needed.

Advise the directors of V Limited whether they should purchase Machine Alpha or Machine Beta. Justify your answer by evaluating both the financial and non-financial factors provided.

Answer:

Machine Alpha

• It has a much higher Net present value ($33 340 vs $15 160), which means it will generate significantly more overall wealth for the company's shareholders.

• It has a shorter payback period (2.57 years compared to 2.92 years), making it a less risky investment, as the initial capital is recovered sooner.

• The initial capital outlay is $80 000 lower, which puts less strain on the company's liquidity and requires less financing/borrowing.

• Both the ARR (22.5%) and IRR (18.2%) are significantly higher than Machine Beta and comfortably exceed the 10% cost of capital.

• Because it is manufactured locally and similar to existing machinery, workers will require little to no training.

• Maintenance and repairs will be much faster and cheaper to resolve locally, reducing the risk of costly production downtime.

Machine Beta

• While its NPV is lower than Alpha, it is still positive ($15 160) and its IRR (12.35%) still exceeds the 10% cost of capital, meaning it is still a viable, profitable project in isolation.

• The cash flows for Beta are much higher in the later years (Years 2, 3, and 4) than Alpha, but these later cash flows are more susceptible to inflation and forecasting uncertainty, increasing the risk.

• It uses advanced technology which produces a higher quality finish; this could allow V Limited to charge a premium selling price or gain a competitive advantage in the future.

• Sourcing repairs from an overseas engineer could lead to severe production delays, lost sales, and expensive repair bills if the machine breaks down.

• The advanced automation will require time-consuming and potentially expensive staff training, which could cause a temporary drop in productivity.

The directors should definitely choose Machine Alpha. Not only is it vastly superior across every single financial metric, especially its higher NPV and lower initial cost, but the local maintenance and lack of training required make it a much safer operational choice.