The University of Phoenix simulation titled "Utilizing the Time Value of Money" concentrated on financial principles used in assessing and deciding between outsourcing manufacturing or investing in in-house operations. The simulation presented real-life scenarios showcasing how investment choices affect Net Present Value (NPV), Internal Rate of Return (IRR), and Cost of Capital. The simulation aimed to apply time value of money principles in evaluating investment alternatives for Cracker Pop.
In every scenario of the simulation, net present value and internal rate of return were utilized to decide the best option regarding outsourcing or investing in a new plant for the card operations of the company. In the second scenario, problems arose with outsourced production when considering the debt-equity mix. The decrease in long-term interest rates made it more profitable for InnoVista t
...o invest in an extra plant with a 60% - 40% debt-equity mix. The third scenario focused on assessing the criterion for increasing production.
To satisfy consumer demands for Cracker Pop cards, InnoVista discovered that the best method was to maintain the same debt-equity mix as in the second scenario, increase manufacturing to 900,000 units, and add another shift. This strategy led to a low cost per capital and a high NPV. Along with NPV and IRR, businesses also take into account the payback period when assessing potential investments. The payback period estimates the time required to recoup the investment's cost and evaluates its long-term desirability.
The payback method is not ideal because it does not consider important principles such as the time value of money and the profitability and risk associated with an investment (Answers Corporation, 2007). Other methods, such as ne
present value and internal rate of return, are usually preferred for these reasons. However, net present value also has drawbacks, one of which is its sensitivity to discount rates.
Any fluctuation in the discount rate will impact the final outcome of the net present value (NPV). Furthermore, NPV does not take into consideration the value of any real options embedded in the investment project. The cost of capital plays a crucial role in connecting an organization's long-term investment decisions with the wealth of the owners, as determined by investors in the marketplace (Gitman, 2006). Therefore, changes in the cost of capital directly influence investment decisions. The measurement of cost of capital is primarily used to analyze potential financial risks associated with investments and to assess the minimum return required to cover the organization's financial obligations while meeting shareholder demands. By considering the costs of both debt and equity, an organization can make forecasts regarding whether the return on capital will surpass the cost of capital. If the cost of capital exceeds the return, the investment will have a significant impact on the organization's financial obligations and will impede its NPV, ultimately leading to negative effects on stock prices.
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