Understanding management accounting and financial management - Assignment Example

?Flight high ventures plc Evaluation of the R&D projects: Project ‘A’ and ‘B’ Flight high ventures plc has turnover growth of 10% and planning to improve more by expansion through new market development. New market development is through exporting the product in new countries. For this expansion setting up new plant is essential for Flight high ventures plc to increase the capacity. The inception of new plant will require initial outlay of ?4m. Along with this, research and development department is taking another project of product development with two options A and B. In this report these two options are evaluated using different techniques. Two projects A and B both are mutually exclusive need to decide which project is more suitable for the Flight high ventures plc. Both the projects have initial capital investment which is shown in annexure as negative. Project B has initial investment of ?1210000 and project A has lower initial investment of ?968000. Lower initial investment does not signify that it is better to accept or reject because there is difference in economy of scale in those projects. Hence the effect is reflected in profit earning and in cash flows per year. These two projects are evaluated using four different techniques like payback method, accounting rate of return method (ARR), net present value (NPV) and internal rate of return (IRR) (Collier, 2003, 185-193). Payback for the project A is 2.5 years and for project B is 3.5 years. Hence project ‘A’ needs 4.5 years to get repaid by its cash flow and project ‘B’ needs 3.5 years. This pay back period depends on the amount of investment and size of cash inflow. If the project has higher cash inflow at the initial time of the tenure of the project then it will effect on the payback time to be lessened. This concept is an advantage to pay back process as the risk of payment through early payment is reduced in this process. Another few advantages are like easy to calculate, simple concept and consideration of cash not profit only. But this procedure of evaluation has major flaw of non consideration of time value of money. Payback concept does not consider the cash inflow out of the stipulated time which may be for infinite for some projects. Hence the project size and the time are not under consideration of this method. (Kay, 2011, p.108) Accounting rate of return of any project is based on the average accounting profit and average capital investment. Here profit is considered in the calculation instead of the cash flow. Profit is counted after excluding depreciation from the cash flow. This ARR calculation has similarity with other calculation for return on investment (ROI) and return on equity (ROE). Only dissimilarity is in denominator. In ARR the main benefit than payback is the consideration of the project life span. Simple in calculation of ARR is another advantage. The result of ARR can help to compare more than one project and also with other financial ratios. But main advantage is similar to payback is, not of considering the time value. Other disadvantages are like not considering the scale of the project and timing (Atrill and McLaney, 2006, p.329- 332). (Damodaran, 2002) In those above two methods risk is considered in the calculation but inflation and interest foregone factor is not considered. In the NPV and IRR method time value of money is applied in the calculation. In NPV calculation the absolute size of the project is accounted and also in the discounting factor consideration of calculation of the discounting rate is important (McGrath, 1998). Usually cost of capital is considered in this calculation but this is the main advantage of NPV method, because of the hardness in calculation of cost of capital (Brigham, Enrhardt, 2010, 383). IRR is positive for the projects with unknown discount rate but known cash flows. Like NPV, IRR also considers risk and time value of money. But IRR ignores the change in discount rate and also the gives multiple result for the cash flow with combination of inflow and out flow. NPV can be considered as the best method in the project evaluation but IRR comes next to it (Gitman, 2007, p. 267) Recommendation   NPV IRR ARR Payback Period Option A $487.06 0.43 0.45 2.5 years Option B $744.37 0.37 0.64 3.5 years Project A has shorter payback period than projects B. Comparing both the project ‘A’ and ‘B’, as per decision rule project ‘A’ is acceptable. Because any project with shorter payback period, should be selected. Reason of shorter payback time for project ‘A’ than project ‘B’ is because of the lower capital investment and higher initial cash inflow. In the second year cash in flow for project ‘A’ is 726000GBP comparing to project ‘B’ is only 424000GBP. In this second year 75% of the investment is returned back for A but only 35% returned back for project B. ARR of the project is ‘A’ is 45% which lower than the project ‘B’. Higher ARR value of project ‘B’ is due to the rapid increase in the cash flow. Comparing to A the cash flow is decreasing with time. Hence project ‘B’ is risky but higher ARR; according to the decision rule B is acceptable. ROI of Flight high ventures plc is only 20%. Hence both projects will increase the return of the Flight high ventures plc (Drury, 2004). NPV of project ‘B’ is higher than project ‘A’ of Flight high ventures plc due to the higher profits and cash flows than. As per NPV decision rule a project with higher NPV should accepted. Hence project ‘B’ is acceptable. Option A 43% Option B 37% IRR of project ‘A ‘is 43% and IRR of project ‘B’ is 37%. Hence the project ‘A’ has higher rate than the project ‘B’. This rate is higher then the cost of capital (Phillips, Bothell & Snead, 2002, p.178). As per the IRR decision rule, A is acceptable. A has higher value in IRR, because the cash flow pattern. As the figure above A has stiff line because of the initial return or payback period is short (Brealey, & Myers, 2003, p.225). Method Acceptable project Reason Payback A Shorter period ARR B Higher % rate NPV B Higher value IRR A Higher rate From above discussion it can be inferred that out of the four tests, results of two tests tell to accept project ‘A’ and another two tests tell to accept project ‘B’. As payback and ARR is not advanced technique for evaluation. Reason of this is of not considering the time value but again the NPV identifies project ‘B’ and IRR identifies project ‘A’. This confusion can be resolved by considering the Fisher’s interaction rule. According to this rule project with higher NPV should be considered (Alchian, 1955). Hence Flight high ventures plc should consider Project B. References Alchian, A. A.(1955)The Rate of Interest, Fisher's Rate of Return over Costs and Keynes' Internal Rate of Return The American Economic Review Vol. 45(5),938-943 Atrill, P. & McLaney, E. (2006) Accounting and Finance for Non-Specialists. 5th edition. Harlow, Financial Times/Prentice Hall. Brigham, E. F & Enrhardt, M. C. (2010) Financial Management: Theory and practices. 13th illustrated. Canage learning Brealey, Richard A. and Myers, Stewart C., 2003. Principles of corporate finance.7th ed. Irwin: McGraw-Hill. Collier,P.M. (2003) Accounting for managers: interpreting accounting information for decision-making.Oxford road. John Wiley. Damodaran, Aswath.,2002. Investment valuation: Tools and techniques for determining the value of any asset. 2nd ed. New York: John Willey & Sons . Drury, C. (2004) Management and Cost Accounting. 6th edition. London, International Thomson Business Press Gitman. (2007) Principal of magerial finance. 11th edition. London. Pearson Education. Kay, R PMP(2011) Examination Study Guide - Role Delineation Study Edition, PMP McGrath, G. (1998) Evaluation Techniques for Capital Budgeting. [Online] Available from: http://www.accaglobal.com/archive/sa_oldarticles/39709 [Accessed 20th April 2011] Phillips,J.J, Bothell,T,W & Snead, G.L. ( 2002) The project management scorecard: measuring the success of project management solutions. Butterworth-Heinemann Appendix Option A   Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 ?000 ?000 ?000 ?000 ?000 ?000 Net Profit   532 290 169 48 48 Depreciation*   194 194 194 194 194 Net Cash flow -968 726 484 363 242 242 Option B   Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 ?000 ?000 ?000 ?000 ?000 ?000 Net Profit   182 242 363 545 605 Depreciation*   242 242 242 242 242 Net Cash flow -1210 424 484 605 787 847 Calculation for Payback Option A 1 2         -242 242 0.5 so 2.5 years   Option B 1 2 3       -786 -302 303 -0.499 so 3.5 Option A: -968+726= -242 and -242/484 =0.5 approximately Option B: -1210+ 424+484= -302 and -302/605=0.5 approximately Calculation for ARR Average Profit Average cost ARR 217.4 484 0.449173554 387.4 605 0.640330579 Calculation of IRR NPV Option A Option B 14% $487.06 $744.37 15% $457.95 $690.04 20% $330.95 $457.90 25% $229.47 $278.90 30% $147.68 $139.69 40% $26.99 ($55.27) 45% ($17.61) IRR is calculated using above interpolation formula or in excel it can be calculated using IRR (). Calculation of NPV Option A $487.06 Option B $744.37 Difference between the present value expected future benefits and the capital invested is the net present value. Discounting to present value is done here using the cost of capital. I0 for option A is -968 and for option B is -1210. C1 is 726, C2 is 484 etc are the cash flows for option A and C1 is 424, C2 is 484 etc are the cash flows of option B. NPV () function is used for the calculation in excel. Read More