This report evaluates the viability of a new machine that is to be purchased by Hawthorn Hospital Equipment Ltd using two methods of evaluation: the payback period and the net present value. The report then makes a recommendation on whether the new machine should be purchased or not.
Evaluation of the new machine
The payback period calculates how long it would take for a firm to recover the amount of money it invests in a project from the cash flows generated from the project. Companies normally have a required payback period, in which case the company would only accept a project if it has a payback period that is equal to or less than the company’s required payback period. If the company is choosing between competing projects, the company would accept the project with the lowest payback period (Graham, Smart, & Megginson, 84).
In our case, the payback period calculates how long it would take for the hospital to recover the amount of money it invests in the new machine from the cash flows generated from the machine. For the required investment, we add the installation costs to the cost of the machine.
Since the hospital’s required payback period is 3 years, only projects that have a payback period of 3 years or less can be accepted by the hospital. The payback period of the new machine can be calculated as follows:
From the computation above, the project would never pay back the investment because the cumulative cash flows in its life are less than the required investment. Using the payback period as a criterion for evaluating the viability of the new machine, the machine should not be purchased because it is not a viable project.
Discounted cash flow valuation technique
This technique forms the basis on which all other valuation techniques were built. The Discounted cash flow valuation technique is based on the principle that the value of an asset is equal to the value of the future benefits that are brought about by that asset. In this technique the present value rule is used, where the present value of an asset’s cash flows is calculated by discounting the cash flows by the cost of capital used in purchasing the asset. (Emery, & Finnerty, 97).
The main limitations of this technique are that finding out the precise value of cash flow in the future is not possible, and also finding out the discount rate is difficult. If the wrong discount rate is used, then the whole calculation of the present value of cash flows will be wrong, resulting in a wrong valuation of the asset in question. The price may therefore deviate from the intrinsic value due to future market conditions.
Relative Valuation technique
This technique equates the value of an asset to a similar asset that is available in the market. The value of an asset is therefore derived from the pricing of a comparable asset. Price multiples are created by standardizing the market value of the comparable asset.
Comparison is then made between the prices multiples for the asset being analyzed and the comparable asset, allowing for effects of differences between the firms. This comparison helps in judging whether the asset is correctly valued. If the price multiple for the asset being analyzed is far much below that of the comparable asset, then the asset being analyzed is said to be undervalued. If the price multiple for the asset being analyzed is far much above that of the comparable asset, then the asset being analyzed is said to be overvalued. If the price multiple for the asset being analyzed is almost the same as that of the comparable asset, then the asset being analyzed is said to be correctly valued. (Keown, Petty, Martin, & Scott, 86).
Common variables such as earnings, cash flows, book value or revenues, can be used in the standardization. Earnings multiples used in the standardization are value/earnings before interest and taxes; value/cash flow; value/earnings before interest, taxes and depreciation; and value / price-earnings ratio and variants.
- Examples of book value multiples are Price / Book Value of Equity; value / Book Value of Assets; and value / Replacement cost.
- Examples of revenue multiples are Price / Sales per share; and Value / Sales
There are four steps to understanding multiples:
Define the multiple: Different users can define the same multiple in different ways, so it is important to understand how multiples are estimated by someone else were estimated before using them (Emery, Finnerty, 77).
Describe the multiple: It is important to know the cross-sectional distribution of a multiple before using that particular multiple.
Analyze the multiple: The relationship between the multiple and each variable should be understood.
Apply the multiple.
Contingent valuation methods
This method values ecosystem and environmental services (Brigham & Ehrhardt, 68)
This method is the most preferred among the few methods for valuing non-use values of the environment in dollars. Such are values that do not involve market purchases (Block, Stanley, & Hirt, 76).
Net Present Value
Under the net present value method of evaluation, the present value of all money that a project is expected to generate during its life is computed by multiplying those cash flows by the present value interest factor at the firm’s cost of capital. The present value of the cash outflows is then subtracted from the present value of the money expected to be received to get the net present value of the project. If a project has a positive net present value, it means that the present value of the money to be received is higher than the present value of the money to be spent on the project. For a project with a negative net present value, it means that the present value of the money to be received is less than the present value of the money to be spent on the project. Such a project will increase the value of the firm by the amount of the project’s net present value. A project is accepted if it has a net present value that is higher than zero, which means that the present value of the money to be received is higher than the present value of the money to be spent on the project. If the company is choosing between competing projects, the company would prefer the project with the highest payback period (Graham, Smart, & Megginson, 84).
In our case, the present value of the net cash flows of the new machine can be calculated using the table below:
|cost of new machine||-1,200,000|
|Market Value of old machine||129,500|
|After-tax Savings on operating costs||175,000||175,000||175,000||175,000||175,000|
|Tax savings on incremental depreciation||39,840||39,840||39,840||39,840||39,840|
|Net Proceeds from sale of machine||140,000|
|Present value interest factor||1||0.917||0.842||0.772||0.708||0.652|
|Present value of Cash flows||(1,220,500)||197,101||180,895||165,856||152,107||231,356|
From the net cash flows calculated in the above table, the net present value of the new machine can be calculated as follows:
|Net Present Value||(293,184.92)|
Using the net present value method of evaluation, the machine should not be purchased because it is not a viable project. This is because its net present value is negative.
The hospital should not purchase the new machine because it is not acceptable under both the payback period and net present value methods as evaluated above.
Block, Stanley, & Geoffrey Hirt. Foundations of financial management. Irwin: Mc Graw, 2006.
Brigham, Eugene, and Michael Ehrhardt. financial management: theory and practice. Florence: Cengage Learning, 2008.
Emery, Douglas, & John Finnerty. Corporate Financial Management. Prentice-Hall: Pearson Education, Inc, 2007.
Graham, John, Scott, Smart, & William Megginson. Corporate Finance: Linking Theory to What Companies Do. South-Western Educational Publishing, 2009.
Keown, Arthur, John Petty, John Martin, and David Scott. Foundations of Finance. New Jersey: Prentice Publishing, 2007.