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Investment decisions and strategies

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Discounted cash flow (DCF) analysis is a family of techniques, of which the N--P
method is just one variant. Two other DCF methods are the internal rate of retut
(IRR) and the profitability index (PI) approaches. Many managers prefer to ur
non-discounting approaches such as the payback and return on capital method
others use both approaches. The following example illustrates the varior
approaches to investment appraisal.

Example: appraising the Lara and Carling proiesfs

Sportsman plc is a manufacturer of sports equipment. The firm is considerir
whether to invest in one of two automated processes, the Lara or the Carling, bo'
of which give rise to staffing and other cost savings over the existing process. Tl
relevant data relating to each are given below:

Lara Carling
f. f.

Investment outlay (payable immediately) (40,000) (50,000)

Year I Annual cost savings 16,000 77,000
2 Annual cost savings 16,000 17,000
3 Aunual cost savings 16,000 17,000
4 Annual cost savings L2,000 17,000
The required return is 14 per cent p.a.

The investment outlays are obviously additional cash outflows, while the annu
cost savings are cash flow benefits because total annual expenditures are reduce
as a result of the investment,

Should the company invest in either of the two proposals and if so, which

The NPV solution

The net present value for the Lara machine is found by multiplying the annual cal
flows by the present-value interest factor (PVIF) at 14 per cent (using the table
and finding the total, as shown in Table 5.1. An immediate cash outlay (treated
Year 0) is not discounted as it is already expressed in present value terms. The san
factors could be applied to evaluate the Carling proposal. Howeve{, as the annu
savings are constant, it is far simpler to use the present-value interest factor for i
annuity (PVIFA) at 14 per cent for four years.
Comparison of the two proposals reveals the following:
1. The Lara machine offers a positive NPV of f4,252, and would increase
shareholder wealth.
2. The Carling machine offers a negative NPV of E467 and would reduce value.
3. Given that the proposals are mutually exclusive (i.e. only one is required), th<
Lara proposal should be accepted.