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The IRR calculation is normally done in Excel, but can be rendered as
The IRR for the patent coating option is 6.9%; for the automation technology it is 64.7%; for the brokerage option it is 11%.
The net present value (NPV) discounts the cash flows using the discount rate derived from the weighted-average cost of capital. This calculation utilizes all of the cash flows that are specific to the decision at hand, including the initial outlay, salvage value and all cash flows beyond the payback period. This makes the NPV the most complete of the capital budgeting techniques available to Guillermo. Although normally this calculation is completed in Excel, the formula is as follows:
For the patent coating scenario, the NPV is -$26,755; for the automation technology it is $955,065; and for the brokerage option it is $27,014. These results are consistent with the results for the IRR and the two payback period calculations.
Sensitivity Analysis
Before Guillermo proceeds, he will need to subject these calculations to a sensitivity analysis. By adjusting some of the key variables, Guillermo can better understand the degree to which the final numbers are sensitive to real world deviations from the expected figures. For example, if the discount rate increases as a result of these investments, it may change the NPV ranking of the different options, depending on the timing of certain cash flows. Taking a discount rate of 12%, the patent coating option would now have an NPV of -$59,430; the automation technology would now have an NPV of $804,982; and the brokerage option would now have an NPV of -$12,091. The sensitivity analysis reveals therefore that the brokerage option's positive...
Should taking this option increase the cost of borrowing such that it raises the WACC or if the company issues equity to pay for the initial investment, thereby raising the cost of capital, this option would no longer be profitable.
Recommendation
In this situation, the automation technology option is clearly the strongest for Guillermo. It has the highest NPV and shortest payback period of any of the three options by far. The positive discounted net cash flows are strong enough that they withstand sensitivity analysis. For example, if the future cash flows from this option are about half of what is projected, at $100,000 per year, the project would still have a positive NPV of $341,766. This means that the project is sufficiently lucrative for Guillermo to explore. The other two projects are not robust enough to withstand challenges to the cash flow or discount rate assumptions. The three projects are mutually exclusive, so Guillermo must select only the one with the highest net present value. Thus, it is recommended that Guillermo must invest in the automation technology.
Conclusion
The value of capita budgeting techniques is that it allows a firm to understand the cash flow implications of investment decisions. When faced with multiple mutually exclusive options such as Guillermo was, these calculations can help the company make the best decision. The sensitivity analysis is a key element in the financial analysis of any capital budgeting decision, because it tests the robustness of the decision in the face of multiple negative scenarios regarding the expected cash flows. In this case, the option chosen withstood…
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