Coyote and Bird run the Acme Fireworks Company and are trying to decide whether or not...

Coyote and Bird run the Acme Fireworks Company and are trying to decide whether or not to purchase new equipment to streamline the production process. Coyote argues that they should use IRR as the basis for making the decision while Bird argues they should be using the NPV. They ask you, as the chief financial officer of the company your thoughts on the capital budgeting decision. What do you tell them?

Expert Solution

Both the methods of capital budgeting have their merits & demerits. As a chief financial officer, I will ask them about the production process and how it will work. What kind of cash flows will the new equipment generate.I will ask them whether there will be equal amount of cash flows every year or uneven cash flows or positive or negative cash flows. For how long the new equipment is going to be used. Because if the cash flows are of equal amount and positive or equipment life is not very long, then IRR method is suitable. In case of uneven cash flows (or negative cash flows) or longer equipment life, NPV method is suitable. IRR method assumes that market conditions, risk conditions , cash flows etc will remain same over the life of the equipment. This may be true for the project's with short life span. In longer periods, they all may vary. Market conditions, interset rates etc tend to change and a project can have multiple distinct IRR values.NPV can handle multiple discount rates easily. Each years' cash flows can be discounted separately from the others. Also, I will ask them whether they have the required discount rate available from which IRR is to be compared. Whats is the cost involved in discount rate. NPV method do not need discount rate. So, to sum up it actually depends upon the situations or outcomes, regarding the choice of method to be used for capital budgeting.

ekkarill92 answered 1 year ago

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