As the corporate business financial analyst of Sparklin Automotive Company (SAC), I have the challenging task of determining whether or not SAC should purchase the new equipment to manufacture the specialty spark plugs. The new equipment will allow SAC to produce 100,000 additional spark plugs per year, with a life span of 5 years and presently no salvage value. In addition, the equipment depreciates using the straight-line method, with an average selling price of $20 and a cost of $8 to produce. There is an expectation of no changes to the indirect cost, a purchase and install cost of $3,000,000, and a tax rate of 34%. This paper will explain the straight-line method for depreciation, the weighted average cost of capital (WACC), as well as net present value (NPV), the internal rate of return (IRR), and the payback period. This paper will discuss and analyze the appropriate tools to determine if the company should purchase the new equipment and how the decision was arrived at.
The first are to discuss is the straight-line method for depreciation. The straight-line method is a process to calculate the depreciation of an asset with the assumption that the asset will decrease in value in equal amounts each year. The method is calculated by subtracting the salvage value of the assets from the initial investment and then it is divided by the number of years of useful life (Investor, 2012). Since the new equipment is not expected to have a salvage value, to get the annual depreciation amount the initial investment was divided by the number of useful years (3,000,000/5 = 600,000), this equation shows the depreciation value.
Next is the WACC, which is a calculation of the company’s cost of capital in which each category of capital is balanced. All capital sources are included in the calculation a WACC. The WACC of a company increases as the beta and rate of return on equity increases, as an increase in WACC notes a decrease in valuation and a higher risk (Atkinson, 2008). Any investments cost of capital should be above the WACC percentage to be considered a sound investment by the company. The intention of the WACC is to determine if the value of an intended investment or project is worth the undertaking (Garrison, 2012). The WACC is calculated by multiplying (equity) percent of capital and after tax cost of capital and adding (debt) percent of capital and after tax cost of capital equals the WACC ((.14*.60) + (0.0396*.40) = 9.984, this total is the WACC.
The third capital budgeting tool is net profit value (NPV). NPV is the amount of the present value of all the cash inflow and cash outflow. NPV is the conventional method for evaluating the measurement cash flow. It is also an amount that states how much value an investment will produce (Investopedia, 2012). The reason for utilizing the NPV method is to figure out which projects are deemed positive or negative to take on. Projects that are positive which are above zero should be considered by a company and those that are negative which is below zero should not be considered. NPV is calculated by subtracting the initial investment from the total present value (Garrison, 2012).
Next is the internal rate of return (IRR), which is the discounted rate that has an NPV of zero for future cash flow. The IRR is utilized to make a decision on which investment should or should not be taken on. The IRR does not account for the risk of the reinvestment rate. Its main purpose is to calculate the breakeven rate of return which shows the discounted rate. It is also utilized in the process of decision making when choosing whether or not to take on a project (Gitman, 2007).
The last one to discuss is the payback period which centers on the recovery of the costs of an investment. The main idea of the payback period is to show that a good
