Business Appraisal in Decision Making - Essay Example

Business Appraisal in Decision Making Introduction In business appraisal, there are various analysis tools that we can apply to provide good accounting information that can be used in decision making. Some of these analysis tools include the use of ratios, capital budgeting criteria as well as costing methods. Good managers rely on the use of well-informed accounting information to make investment as well as production decisions in their firms[Car131]. However, some of the methods they use for appraisal have some limitations when used independently[Jon08]. This report will focus on advising NENE Limited based on the calculation results from various case scenarios to help the management will informed decision making on project choice and well as costing methods to choose. Question One a) Calculations i) Projected Cash Flows Cash flows for Project Alpha: 　Time in Years Cash inflow/outflow (£) Depreciation (£) (100,000 – 10,000) / 5 Disposal proceeds (£) Cash Flows (£) Cumulative cash flows (£) Year 0 (100,000) 0 0 (100,000) (100,000) Year 1 15,000 18,000 0 33,000 (67,000) Year 2 18,000 18,000 0 36,000 (31,000) Year 3 20,000 18,000 0 38,000 7,000 Year 4 32,000 18,000 0 50,000 57,000 Year 5 18,000 18,000 10,000 46,000 103,000 Year 6 2,000 0 0 2,000 105,000 Cash flows for Project Beta: Time in Years Cash inflow/outflow (£) Depreciation (£) Cash Flows (£) Cumulative cash flows (£) Year 0 (90,000) 0 (90,000) (90,000) Year 1 20,000 30,000 50,000 (40,000) Year 2 25,000 30,000 55,000 15,000 Year 3 (50,000) 30,000 (20,000) (5,000) Year 4 10,000 25,000 35,000 30,000 Year 5 3,000 25,000 28,000 58,000 Year 6 0 25,000 25,000 83,000 ii) Payback Period For Alpha Project = 2 + 31,000/38,000 = 2 + 0.8 = 2.8 years For Beta Project = 3 + 5,000/35,000 = 3+5/35 = 3 5/35years iii) Accounting Rate of Return ARR = Average Annual Operating Profits / Average Investment Amount x 100% For Alpha Project; ARR = AAOP before depreciation = (33,000+36,000+38,000+50,000+46,000+2,000)/6 = 205,000/6 = 34,167 After depreciation= 34,167-18,000 = 16,167 Average investment = (100,000 – 10,000)/ 2 = 55,000 ARR = 16,167/55,000 x 100 = 29.4% For Beta ARR = AAOP before depreciation = (50,000+55,000+-20,000+35,000+28,000+25,000)/6 = 173,000/6 = 28,833 After depreciation = 28,833 – 27,500 = 1,333 Average Investment = (90,000 +75,000)/2 = 82,500 ARR = 1,333/82,500 x 100% = 1.61% iv) Net Present Value NPV for project Alpha: Time (years) Cash flows (£) Discount factor (14%) Present value £ Year 0 (100,000) 1 (100,000) Year 1 33,000 0.877 28,941 Year 2 36,000 0.769 27,684 Year 3 38,000 0.675 2,565 Year 4 50,000 0.592 29,600 Year 5 46,000 0.519 23,874 Year 6 2,000 0.456 912 NPV 36,661 NPV of project Beta: Time (years) Cash flows (£) Discount factor (14%) Present value (£) Year 0 (90,000) 1 -90,000 Year 1 50,000 0.877 4,385 Year 2 55,000 0.769 42,295 Year 3 (20,000) 0.675 (13,500) Year 4 35,000 0.592 2,0720 Year 5 28,000 0.519 14,532 Year 6 25,000 0.456 11,400 NPV 29,297 b) Recommendation Based on Calculations Projected cash flows represents the forecasted movement of cash within a given project. The higher the cash flow, the more preferable the project is since it lets in more cash[Kou06]. Alpha has a cash flow of 105,000 pounds while it is projected that Beta will have a cash flow of 83,000 pounds by the end of the project’s life. Alpha will make a better project for NENE than Beta if implemented. On the basis of payback period, a project that can repay its initial invested amount faster enables the owners to begin collecting profits early[Ave11]. Such a project is usually chosen when there is one another one with a longer payback period. Alpha project will repay its initial invested amount within 2.8 years. While Beta project will repay after within 3.1 years. Alpha will repay earlier than Beta, therefore, NENE Limited should choose Alpha project. The criteria for using Accounting Rate of Return is that, the higher the rate, the more efficient the project. The rate shows the rate at which the project will give back its returns[Kap00]. A project that gives back its returns at a higher rate is most preferred. Alpha project has an ARR of 29.4% while Beta project has ARR of only 1.6%. It is clear that Alpha will give higher returns faster than Beta. The management should, therefore, choose Alpha project. When using the Net Present Value, it is advisable that the project with a positive NPV be accepted[Fei02]. NPV shows the forecasted present value of the project by the time of its completion[Shr01]. A positive NPV therefore, shows that, the project will achieve a profit. A project with a higher NPV is more preferred since it increases the shareholders’ income. Alpha project has a NPV of 36,661 pounds while Beta has 29,297 pounds. It is, therefore clear that Alpha project should be accepted as more preferred than Beta project. c) Discussion of the Methods Internal Rate of Return This is usually the discount rate that is used in the capital budgeting decision making in which the net present value of a project is equated to be zero. A general criterion for IRR is that, the higher the IRR of a project, the more desirable the project is to be undertaken. For this reason, several prospective projects can be ranked using their resultant IRRs. When all other factors are considered equal in all the projects, that project that will have the highest IRR will be preferred over the others[Mos13]. IRR is preferred as it considers the time value for money, it is simple to calculate and requires no hurdles rate. On the other hand, IRR does not consider the size of the project, it also ignores the future costs and reinvestment rates. Payback Method Payback period represents the amount of time that a project or an investment takes before its initial starting amount is realized. In otherwise, the time it takes for a project to breakeven. A project that takes the shortest period to give us the starting amount will always be the best project for us because we cannot wait to begin enjoying the profits. When making a decision on the project to choose, it is therefore required that their payback periods are calculated and used to compare them[Haj93]. This method is easy to use and is loved for its simplicity. It also focuses on cash. It is very important for firms to identify projects that give the fastest returns and this is only possible through the use of payback period method. Many managers also like using payback period when the want to make a quick evaluation of small investments. However, it does not consider the time value for money. It does not also consider all the cash flows after the period. In some cases, it is hard to apply this method as cash flows may not be regular. Some of the capital expenditures usually take longer periods to payback, but continues to provide positive cash flows for a very long time. Such projects are ignored when using this method. Accounting Rate of Return In any investment we make, our main focus is usually on the profits. That, is why ARR focuses on the profit we expect form an investment. We use the amount of initial investment to divide the average profit expected to give us a return amount or a ratio which becomes the return we expect[Bui09]. Because of this factor, ARR has the ability to make an investor compares the expected return from various projects and choose the most desirable one for them. The higher this value is, the more profit a project is most likely to have. The method is advantageous by the fact that, the calculation is given in a percentage form which is easy to use when doing a comparison with the expected return of the project. The method also considers all the profits of the project, therefore, it evaluates the whole project. This method provides easy comparison of projects and it is also used to eliminate outlying statistics. The method also has a flexible time frame where it can be used to cover any period that is specified by the investor. On the other hand, this method does not consider the time value for money as it does not also consider the use of the cash flows of the project. Another major disadvantage is the fact that, this method does not recognize the terminal project amount. Net Present Value Net Present Value simply is the difference between the cash flowing in the business and the cash moving out of the business. It is one of the main methods that are widely used when assessing the profitability of an investment. Any project or investment with NPV above zero should be accepted since it increases the shareholders’ income[Mie10]. However, those projects with NPV below zero, usually reduce the shareholders’ income, therefore, are rejected. In a case where there are many projects with NPV above zero, the one with a larger NPV is normally chosen since it is considered more efficient than that which has a smaller NPV. This method utilizes all the cash flows of a project, hence is more appropriate. It is also the only method that considers the time value for money. NPV is also preferred as it considers all the cash flows before and after the project’s lifespan. When maximization of the firm’s value is required, NPV is the most appropriate method to use. However, the method is cumbersome to use since its calculation is complicated and the cost if project startup must also be considered. This method is also very difficult to use as it involves complicated calculations. It may also not give an accurate decision making as the projects may not have equal life. Question 2 a) Ratio Analysis i) Return on Capital Employed (ROCE) = Net Operating Profit ÷ Capital Employed ROCE for Benjamin = Net Operating profit = 10,000 Capital Employed = 42,000 (25,000+5000+12,000) ROCE = 10,000÷42,000 = 23.8% ROCE for Peters = Net Operating Profit = 15,000 Capital employed = 44,000 (20,000+8,000+16,000) ROCE = 15,000 ÷ 44,000 = 34.1% ii) Gross Profit Margin = (Revenue –COGS) ÷ Revenue Gross Profit Margin for Benjamin = (80,000 – 60,000) ÷ 80,000 = 25% Gross Profit Margin for Peters = (120,000 – 96,000) ÷ 120,000 = 20% iii) Operating Profit Margin = Operating Income ÷ Net Sales Operating Profit Margin for Benjamin = 10,000÷80,000 = 12.5% Operating Profit Margin for Peters = 15,000÷120,000 = 12.5% iv) Acid Test Ratio = Current Assets – Inventory) ÷ current liabilities Should be (Current Assets – Inventory) ÷ current liabilities Acid-Test Ratio for Benjamin = (45,000 – 15,000) ÷5,000 = 6 Acid-test Ratio for Peters = (40,000 - 17,500) ÷10,000 = 2.25 v) Inventory days = Ending Inventory ÷ (Cost of Goods Sold ÷ 365) Inventory Days for Benjamin = 15,000 ÷ (60,000÷365) = 91.3days Inventory Days for Peters = 17,500 ÷ (96,000÷365) = 66.5 days vi) Trade Receivable Days = Average Gross Receivables ÷ (Annual Net Sales÷365) Trade Receivable Days for Benjamin = 25,000/ (80,000÷365) = 114.06 days Trade Receivable Days for Peters = 20,000/ (120,000÷365) = 60.83 days vii) Trade Payable Days = Ending Accounts Payable ÷ (Purchases ÷ 365) Trade Payable Days for Benjamin = 5,000 ÷ (60,000 ÷ 365) = 30.4 days Trade Payable Days for Peters = 10,000 ÷ (96,000÷365) = 38.02 days b) Ratio Interpretation Profitability Return on Capital Employed, Gross profit margin and Operating profit margin are some of the ratios used to measure the profitability of a firm. Normally, ROCE measures the efficiency with which a firm’s profit is invested[Luq13]. As a result, when this ratio is high, the firm is said to be more efficient in employing its capital. From the calculated values, Peters depicts a higher ROCE of 34.1% than Benjamin, which has only 23.8%. To the managing Director of NENE, it is obvious from these figures that Peters is more efficient in employing its capital, hence, it should be acquired. Gross profit margin helps a firm to determine the amount of revenue that remains after subtracting the cost of goods sold. A financially healthier firm will have higher gross profit margin than a less financially healthy firm[Smi06]. Benjamin has gross profit margin of 25% while Peters has 20%. NENE management should consider Benjamin Limited as it will be able to leave it with more revenue after cost of goods sold is removed. Operating profit margin represents a firm’s revenues after meeting its variable costs[Ric121]. It therefore means that, a firm that remains with more revenue after meeting its variable costs is more efficient than that will less revenue. Benjamin Limited has an operating profit margin of 12.5% while Peters also has 12.5%. Either of the projects should be chosen as they will both make NENE remain with more money even after paying its variable costs. Liquidity To assess the liquidity of these firms, Acid-test ratio will be used. This ratio represents the ease with which a firm is able to pay its immediate liabilities using its cash and cash equivalent assets[Kub10]. Generally, a firm that has an Acid-test ratio of below 1 should be rejected as such a firm is not capable of meeting its short-term obligations while using its short-term assets only. This ratio for Benjamin, is 6 while for Peters is 2.25. They both can meet their short-term obligations with their current assets, but Benjamin is more efficient in doing so than Peters. Therefore, NENE should acquire Benjamin. Working Capital Management When a firm is able to manage well its inventories, it will be able to have adequate working capital[Era10]. Good working capital management can be found with a firm that has shorter trade receivable days and trade payable days as well as short inventory days. Trade receivable days indicate the number of days that it takes for the supplied goods on credit to be repaid. When the days are shorter, the firm will have adequate capital at the required time for investment. Similarly, trade payable days shows the number of days that a firm may take to the goods it took on credit. When the days are longer, the better since the firm will have more days with the money to invest. Inventory days represent the number of days that it takes a firm to convert its inventories into cash. If the period is shorter, a firm is able to receive cash in time for investment. When these days are short, inventories are collected faster into the company, therefore, they can be used for further investment. Peters has shorter inventory and trade receivable days than Benjamin. It should therefore be a better firm in capital management. However, Benjamin has a shorter trade payable days, hence releases the firm out of debt sooner. c) Limitations for Using Ratios Ratios are not widely used for business appraisal since businesses use different accounting methods which affect ratio calculations. Ratios are also affected by various economic situations that affect businesses such as inflation[Naj13]. During such period, ratios may be adversely affected, hence, use of these ratios may not give appropriate decision. Some firms also have various business divisions operating in different industries. In such cases, it is difficult to have a benchmark where ratios from all these divisions can be compared. Ratios cannot also be used on their own to assess a business condition since they don’t capture everything used in the assessment[Alr11]. For experienced financial ratio analysts, they very well know when ratios are giving results that are not easily comprehended. This gives us another drawback of ratios that they can sometimes produce undesirable results that cannot be used for proper analysis. Some ratios are very hard to work with. This is because, it becomes hard at times to know the margins within which some ratios are considered as good or bad. It has also proved to be very difficult to compare ratios from different sources. This is mainly because different ratios are defined differently according to their sources. Question 3 Traditional costing method: Overhead absorption rate (OAR) = £4,410,000/(0.5x20000+1000+10000) =£210 To calculate the indirect costs for each model: 　 A (£) B (£) C (£) Direct Labor Hours 0.5 1 1 Rate of Overhead absorption 210 210 210 Per Unit Overhead absorption 105 210 210 Full cost and per unit selling prices: 　 A (£) B (£) C (£) Direct material 25 62.5 105 Direct labor 4 8 8 Per unit overhead absorption 105 210 210 Per unit full cost 134 280.5 323 Mark-up 20% 26.8 56.1 64.6 Selling Prices 160.8 336.6 387.6 Activity-based costing method: 　 A (£) B (£) C (£) Machine Hours 40.00% 15.00% 45.00% Total overheads of machining 2,780,000 Overheads absorbed 1,112,000 417,000 1,251,000 Production 20000 1000 10000 Per Unit Overhead absorption 55.6 417.0 125.1 　 A (£) B (£) C (£) Material Orders 47.00% 6.00% 47.00% Total overheads of machining 590,000 Overheads absorbed 277,300 35,400 277,300 Production 20000 1000 10000 Per unit absorption overhead 13.9 35.4 27.7 　 A (£) B (£) C (£) Space 42.00% 18.00% 40.00% Total overheads of machining 1,040,000 Overheads absorbed 436,800 187,200 416,000 Production 20000 1000 10000 Overhead absorption per unit 21.8 187.2 41.6 　 A (£) B (£) C (£) Direct material 25 62.5 105 Direct labor 4 8 8 Machining 55.6 417 125.1 Logistics 13.9 35.4 27.7 Establishment 21.8 187.2 41.6 Per unit full cost 120.3 710.1 307.4 Mark-up 20% 24.06 142.02 61.48 Selling Prices 144.36 852.12 368.88 a) Traditional Vs. Activity-based Costing NENE Limited management need to know that Activity-Based Costing is a method of costing that determines all the production associated activities, assigns costs to every activity and finds the cost of the product[Egb13]. On the other hand, Traditional Costing method is one costing method that is used in assigning costs to products depending on the average overhead rate. It is more recommended that the management should employ the use of Activity-Based costing as it proves to be more accurate in cost allocation since more important factors are considered when assigning a cost to a product[Vok01]. It is however, very complicated and consumes a lot of time when being used. This method is very thorough and it gets even non-manufacturing costs done as well. This method cannot be compared with the traditional method which is very easy as it only considers average of overhead cost when assigning costs to products. This method will not make use of no-manufacturing expenses, as a result, it will not be very accurate. Some of the most common advantages of traditional costing method include the fact that it is one method that is very easy to apply. This is because, managers have easy time to trace all the direct costs that are associated with the products. It also provides a very simple way of allocating overhead costs using the direct labor hours. The method is also useful in situations where the company manufactures large numbers of products as it gives an easy way of coming up with the costs of manufacturing products. On the other hand, the method has proved to be very outdated. This method was used long time ago. Currently, there is more use of computers and machines that have really changed the costing system. There has been a reduced need of labor by the technological advancement, hence rendering the method less effective. Activity based system on the other hand has come up to improve the business process. This is through using product cost drivers when allocating indirect costs, which never used to happen. This gives a picture of businesses performing well and in an improved way. The method also helps with the identification of products that are considered wasteful. This method performs this task by ensuring that it accounts for costs that are similar to the way the work of production is performed. On the contrary, ABC method can lead to misinterpretation of data. This may result as the reports produced when using this method has product margins that show variation in information. Another disadvantage of this method is that it is very expensive to implement. It requires a lot of equipment, computers as well as trained manpower to operate and interprets the reports. Conclusion When making investment decision, it is important that the business is appraised using valid methods. Some methods of appraisal cannot be used independently, such as ratios, therefore, their limitation must be considered during appraisal. Financial information, when well presented, is capable of providing decision making help to managers in times of choosing projects as well as when assigning costs. Bibliography Car131: , (Carrahera & Van Auken, 2013), Jon08: , (Jonsson, 2008), Kou06: , (Kousenidis, et al., 2006), Ave11: , (Avery, et al., 2011), Kap00: , (Kapler, 2000), Fei02: , (Feinstein & Lander, 2002), Shr01: , (Shrieves & Wachowicz, 2001), Mos13: , (Mostafa & Dixon, 2013), Haj93: , (Hajdasinski, 1993), Bui09: , (Buijink, et al., 2009), Mie10: , (Mielcarz & Paszczyk, 2010), Luq13: , (Luqman, et al., 2013), Smi06: , (Smith, 2006), Ric121: , (Ricci, 2012), Kub10: , (Kubota & Takehara, 2010), Era10: , (Erasmus, 2010), Naj13: , (Najjar, 2013), Alr11: , (Alrafadi & Md-Yusuf, 2011), Egb13: , (Egbunike, et al., 2013), Vok01: , (Vokurka & Lummus, 2001), Read More