BUSINESS FINANCE Essay Example
Case study: Making GM Firm Investment Decision
This paper seeks to use payback period, net present value, and internal rate of return to reach a replacement decision between machine A and machine B. Payback period indicates that machine B should be purchased because it meets the stipulated maximum payback period of four years. IRR technique as well supports the decision under payback. On the contrary, NPV technique recommends replacing the machine with machine A whose NBV is higher than that of machine B. The conclusion is that the machine with a higher IRR ought to be purchased to attain higher investor returns.
Payback period of machine A
Payback period of machine B
In considering payback period, GM should replace its sawing machine with machine B because it has a shorter payback period compared with machine A.
Applying Net Present Value and Internal Rate of Return
Net Present Value
According to Campbell (2003), Net Present Value is obtained by discounting cash flows together with initial investment at the required rate of return. The NPV for a project is obtained as follows:
NPV of Machine A
NPV of Machine B
GM should replace its sawing machine with machine A because its NBV is higher than that of machine B.
Internal Rate of Return
Applying interpolation formula shown below:
IRR value that is greater than the cost of capital informs the management that the project is valid. The two machines have internal rate of return that is more than the 13% cost of capital. This shows that the machines are able register additional return to stockholders. However, by comparing IRR of machine A and machine B, GM should consider adopting machine B since its IRR is higher than that of machine A.
Because GM carpentering requires all projects to have a maximum payback period of four years, machine B should be purchased.
In considering higher shareholder returns, IRR decision rule shows that machine B should be purchased.
The management however, should look into time value of money. By looking at time value of money, GM ought to invest in machine A whose NPV is higher than that of machine B. Time value of money shows that a dollar received today is valued highly compared with a dollar to be earned in the future.
Campbell, H. (2003). Benefit-Cost Analysis: Financial and Economic Appraisal Using Spreadsheets. New York: Cambridge University Press.
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