FINC2011 Assessment

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Cicero Mines Investment Analysis
Part 1: Project Evaluation
When making capital budgeting decisions, there are various techniques that can be utilised. Ross et al. (2008) describes that the predominant capital budgeting methods used as being the Net Present value (NPV) method, the Internal Rate of Return (IRR) method, the Payback method, and the Accounting Rate of Return (ARR) method. Conversely, Brealey, Myers and Allen (2011) proposes that the NPV and IRR methods are considered prestige compared to the ARR and the Payback Methods, as they take into account the time value of money. Thus, the following project evaluation will focus on using the NPV and IRR methods.
NPV Method:
The Net Present Value method discounts future cash flows
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Thus, Cicero Mines should choose Machine B as it has a higher NPV than Machine A. It should be noted that NPV fails to account for the differing useful lives of each machine.
According to Brigham and Ehrhardt (1998) the NPV method has the capability of leading to incorrect conclusions when considering two projects with unlike useful lives. To overcome this problem, Brealey, Myers and Allen (2011) propose to convert the present value of each project to an Equivalent Annual Value (EAV). It should be noted that this method relies on the assumption that the project will be replaced with a similar cash flow pattern. Therefore in this situation, we are able to assume that both Machines A and B have the ability to be replaced by another machine at the end of the useful life. The EAV for each machine is calculated as follows:
$ = = $44,830.57
$ = =
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