Introduction. ABC Mining Company
One of the largest and most known mining companies in the United States. Currently involved in a process of investment discussion and decision-making based on the effectiveness estimation and probable revenue calculation. Constantly trying to achieve a higher position in the overall ranking of US mining companies, get a higher market share, and elevate above the majority of competitors.
Trying to enhance efficiency by investment into new machinery and equipment to provide faster delivery to their clients, get a more preferred position in comparison to the rivals. The implementation of such calculation methods as the payback period method and the time value of money.
Description of the Case Study
Goal: elevating above the company’s competitors in the market by enhancing efficiency in its extraction process.
Methods: the acquisition of the most advanced machinery and equipment in the sector (for example, new hydraulic mining shovels).
Main issue: the discussion by the board of directors whether investment in new equipment and technical machinery will increase the organization’s profit, popularity, and customer preferences or not.
Reason: the constant competition among mining companies worldwide for bigger market hare and increase in revenue. Therefore, the need to strengthen the position of the examined company on the market.
Hypothesis: the implementation of capital budgeting and the related methods as concepts for determining and estimating the correct decision.
Methods of Cost Calculation
The most essential question: will the investment in new machinery help generate more revenue and increase efficiency?
Capital Budgeting as a concept of support for the decision-making process and implemented using two diverse methods:
- Payback period method
- Time value of money method
- The overall characteristics of the payback period method:
- Helps in preparing against risk
- Prefers projects with cash inflows in initial rather than later years
- Is a method of liquidity
The overall characteristics of the tie value of money:
- Valuates investment opportunities
- Is a critical part of risk management and financial planning
The comparison and estimation of both methods being a key factor of making the right decision
Literature Review
Diverse factors influence the success of made decisions. Mostly such factors as micro and micro view of the economy, company, and polity along with project life and cost of the capital.
Factors functions:
- Project life – determination of the complete picture of the project.
- Cost of capital – a discounting factor
Payback period
One of the easiest and the most widely utilized methods or quantitative techniques for calculating capital budgeting.
Function: defines the number of years needed to get back the invested sum of money.
ABC company outlook: the number of years needed to return the investment in equipment and machinery.
Methodology and Results
When uniformity in CFAT – the first method applied (the original cash flow divided by the constant annual cash flow).
When no uniformity in CFAT – the second method applied (cumulating of CFAT until the time when cumulative cash flow equals to the initially invested amount).
Both methods’ result – payback period definition and calculation. => Management’s main role – the definition of the payback period and choice of the appropriate investment proposal based on the calculation results.
The observed tendency:
Duration < utmost acceptable duration = investment proposals accepted. Duration > utmost acceptable duration = investment proposals rejected.
Methodology and Results
The concept of the time value of money:
100$ now = 102$ in the future due to investment
BUT
0$ now = 100$ in the future => The worth on money right now ≠ not similar to what its future value will be.
Interest rates as the crucial factor defining the TVM are impacted by diverse factors:
The earnings the firm gets from investing the borrowed amount
The amount of funds the firm can borrow
Inflation
Risks involved in the project realization
The main reasons for the time value of money: the time difference, the decrease of the purchasing power, inflation, and related risks.
An important concept for choosing a project: the future cash flows’ obligatory transformation to present value which underscores the relevance of accuracy in setting discount rates.
Definitions
IRR – internal rates of return;
NPV – net present value
Additionally
High NVP = high success after investment
IRR > discount rate = high success after investment
Recommendation
Benefits of investment in the modification of the equipment and machines:
- The recovery of money within a short time period
- Success in the industry and higher customer preferences among competitors
- Time economy, increase in effectiveness
- High levels of customer satisfaction
- Decreasing number of advanced competitors
- Higher revenue due to increasing customer preferences
- Less time consumption for the delivery and production processes
Sum of investment: 10 000 000$; the amount of money earned per annum after the investment: 500 000$; recovery period: within two years after the investment.
In conclusion, investment in new machinery and equipment, as well as their modification, strongly recommended.
Discussion and Conclusion
- A recommendation for the ABC Mining Company to invest in new machines and equipment, based on the study outcome.
- A huge role of management and finance departments in estimation of the benefits and challenges of investment properly.
- The payback period method as one of the most effective techniques of calculating the duration of investment return. In addition, widely utilized by diverse organizations and companies around the world.
- Dependence of investment decision-making on diverse factors such as micro and micro view of the economy, company, and polity, or project life as a crucial factor.
- The noticed diversity in payback period method calculation depending on the presence of uniformity in CFAT
- The calculated outcome of 10 years of payback period for the ABC Mining Company returning 10 000 000 $ of investment
References
Almazan, A., Chen, Z., & Titman, S. (2017). Firm investment and stakeholder choices: A top‐down theory of capital budgeting. The Journal of Finance, 72(5), 2179-2228. Web.
Lima, A. C., da Silveira, J. A. G., Matos, F. R. N., & Xavier, A. M. (2017). A qualitative analysis of capital budgeting in cotton ginning plants. Qualitative Research in Accounting & Management. Web.