CU Boxes, Inc. Capital Budget Recommendation on a New Boot Sole Essay

CU Boxes, Inc. Capital Budget Recommendation on a New Boot Sole Machine - Essay Example The CFO has been tasked with offering a recommendation as to whether to stay the course with the current machine, delay the purchase, or buy the machine. For the purposes of this budgetary review and analysis the following assumptions are made: CU Boxes, Inc.'s discount rate shall be 10%. Let's see how the CFO tackles this request. There are two types of investments. "The investment decisions of any business are of two types: long term (where funds are usually invested for more than three years) and short term (where investments are for a year or less)." (Kapil p1). In this case, the boot sole machine, where the payback is longer than a year, is a long-term investment and fits the capital budgeting criteria. "The growth of any company is measured by the expected return multiplied by the amount of funds invested by the firm, that is, g = b x r - where 'g' is growth of the firm; 'b', the funds retained by the firm only for investment purpose; 'r' the required/expected rate of return; and r {gt} k (the cost of capital)." (Kapil p1) What the Kapil's model tells us is that as long as the expected rate of return is greater than the cost of capital (the discount rate at which cost of capital is calculated), there will be positive growth and that this is a good thing to have. "These decisions have to fulfill the criteria of creating net positive present value for the organization. Thus an organization should grab and hold on to every opportunity (both external and internal) that creates positive net present value (NPV) for its shareholders." (Kapil p1). Net Present Value (NPV) defined as "the present value of an investment's future net cash flows minus the initial investment. If positive, the investment should be made [unless an even better investment exists], otherwise it should not," (InvestorWords.com 3257), is one method of analysis used by CFO's. Another is the Internal Rate of Return (IRR) defined as the "discount rate at which the present value of the future cash flows of an investment equals the cost of the investment. When IRR is greater than the required return - called hurdle rate in capital budgeting - the investment is acceptable." (Zephyrmanagement.com/glossary). Using NPV first, we have an immediate outlay of capital and a constant return of cash flow calculated at year-end. NPV can be stated as follows: NPV = (10%, CF1, CF2, CF3, CF4, CF5)+CO where CF is cash flow and CO is cash outlay. In this case, with a discount rate of 10%, the result is a positive $14,998.98 at the end of year four and a positive $14,991.91 at the end of year five. (These calculations were made using an ExcelTM spreadsheet). Based on this NPV analysis the investment should be made and the CFO should make such a recommendation to his company's owners as per Kapil's statement above. Using IRR to determine whether the yield rate in a similar period is larger than the discount or hurdle rate, the result at the end of four years is a yield of 8%, which puts it below the discount rate. However, if the period of calculation is five years the IRR is now 15% and well above the 10% discount rate required. So, if the CFO had only used the IRR analysis for only a period of four years his recommendation might have been to limp along with the current machine, but if he ran the calculation out to five years the recommendation would be the same as