Capital Budgeting Analysis - Assignment Example

?CASE a) Stakeholders include all those parties which hold a direct interest in Jill’s business and are affected by any and every action the organization takes. These parties include not only the customer, shareholders if any but also the suppliers, employees, government, investors which in this case is the bank and government. Jim’s loan will affect the direct variable and fixed costs of production. This will have many serious effects and challenges for the stakeholders. Bank which is the investor as they are lending money to Jill for buying the wood-turning equipment will be highly affected by the success or failure of this project. This is because in case Jill’s operating costs rise and is not able to sell product at high price in the market bank will have default risk and will also face potential payment risks by Jill. Second stakeholders are the employees which might be fired from job because the company might not need them for the more automated system of production. Also, employees with older skills of production might be affected as they will no more be suitable for the job of new production process. Next stakeholders to be effected are customers who might face the issue of high prices in case of high product cost to Jill. Company’s first aim is to cover their costs and hence if Jill’s costs rise with the new equipment it might price the product at a slightly higher price which might not be acceptable to the customers. Lastly, competitors would be affected by this action. This is because competitors might lack the new mode of production and hence they might not be able to produce efficiently compared to Jill’s company. At the same time competitors might also gain as in case Jill raises price of the product, competitors can increase their sales by keeping low price of their product. Changing production technology is what is of more concern and convenience to the internal management of any company and customers have nothing to do with it. So, Jill’s decision might have no effect on its reputation. Hence Jill should think of saving her costs rather than following her high cost passion blindly. (b) Ethics can be defined as any action which synchronizes with the generally accepted principles of right and abandons the wrong. Ethics in business follow the rule of true, accurate and complete information sharing among all the parties with the disclosure of benefits as well as risks of any project. In this case, benefits are being portrayed to the bank by Jill in a very reasonable manner but at the same time. CVP analysis and fixed costs control problem is hidden by Jill because of the fear of not getting the loan from bank. Ethical concern in this case is the true and fair representation of information as the information provided by Jill to bank is not accurate and does not represent every side of the picture. Jill has highlighted the benefits of this project to the bank only in order to get the loan but has been hiding the information of high fixed costs due to this new production equipment. So, Jill has been showing the bank only the bright side of this project and ignoring the area which can bring concern to the management of bank. In this case, bank can be in trouble in future with a high risk of default in case Jill is not able to sustain profits with this new investment. So, Jill is unethically showing the wrong and incomplete side of the picture to bank. © I would think ethically and ensure that I share the full and accurate information with my bank. When we put a proposal in front of a third party who is going to put at stake the money of another third party(bank’s customer) in our business, there is a need to be very sensitive towards all the two parties involved one directly and other one indirectly. So, I would ensure to share the complete results with my bank and appeal for loan. This is because being ethical is the major concern for any business and I would never like to be the reason of trouble for my stakeholders especially those who have invested their money and the money of their customers in my business by trusting my vision. CASE 2 (a) Deep dive adventure Income statement as at May 20xx $ Revenue 2800 Expenses Salary 12000 Fixed expense 39000 Depreciation 3000 Food cost 10 Insurance 24 Drawings 40000 Net income 91234 Deep dive adventure Income statement as at June 20xx $ Revenue 3600 Expenses Salary 12000 Fixed expense 39000 Depreciation 3000 Food cost 10 Insurance 24 Drawings 40000 Net income 90434 Deep dive adventure Income statement as at July 20xx $ Revenue 3200 Expenses Salary 12000 Fixed expense 39000 Depreciation 3000 Food cost 10 Insurance 24 Drawings 40000 Net income 90834 (b) Cash statement as at may 20xx $ Cash inflows Brought down 2000 Deposit (30%) 6 Balance paid 200 Cash outlows 95% of balance 190 Operating expense 23400 Food cost 6 Insurance 14.4 23610.4 Cash statement as at june 20xx $ Cash inflows Deposit (30%) 6 Balance paid 200 1 month in advance (50%) 10 216 Cash outlows B/d 21404.4 95% of balance 190 Operating expense 3900 Food cost 10 Insurance 24 25528.4 Cash statement as at july 20xx $ Cash inflows Deposit (30%) 6 Balance paid 200 2 months in advance (20%) 4 210 Cash outlows B/d 95% of balance 190 Operating expense 3900 Food cost 10 Insurance 24 Loan payment 200000 204124 © The company cannot pay back such a huge sum of money as loan payment; $200,000. Already it is incurring high cash outflows each month. the owner must refrain from taking out such a large sum of money from the company's accounts; $40,000 CASE 3 (a) Final profits for a company are the profits which the company has to distribute among all the capital holders of the company after all payments have been satisfied. Final profits of companies are usually very less and in negatives as well because of the high interest, operating and marketing expenses of firms now days. Gross profits are the direct profits which incorporate the direct costs only. On the other hand, final profits for a firm are the profit which includes all the direct as well as indirect expenses of the firms. The indirect expenses are usually very large and include taxation, interest expenses and the operating expenses which are approximately 40-60% of the total expenses of firms. After paying of all the expenses and due payments, firms are usually left with very small amount. Hence, employees like Ellie who are intelligent enough to understand this fact are usually reluctant to accept the bonuses based on final profits. (b) Gross profits are the immediate profits after the deduction of cost of goods sold from the sales of a company. Usually cost of goods sold make a very significant proportion of the company’s total costs that is about 60%. But despite of the high amount of cost of goods sold, gross profits are usually high and positive for most the companies. Bonuses given to employees based on gross profits would thus be higher compared to the ones who would be given bonuses based on total profits. This is because total profits come after deducting all the expenses from the gross profits which leave a small net income for the firm to be distributed and based for bonuses. So paying bonus on a small amount of profits is always preferable by the firm’s management compared to paying bonuses on gross profits. For example, if a firm have $1000 gross profit and bonus is 5% of the gross profit, they will have to pay $50 to their employee. Now let’s suppose that after deducting all the expenses of salaries, marketing, interest and taxation, the firm is left with $10 of net income on which employees would be given bonuses. So, now they will need to pay only $0.5 to their employees. Another reason is that gross profit does not include the salaries of management so management becomes insecure because they think that paying employees based on gross profits might squeeze their profits as they will be given salaries after the bonus deduction of employees. So, management prefers to give bonuses based on net income rather than gross profits to their employees. © Employees are satisfied when they think they are paid fairly for their hard work and are not underpaid. Overpayment is not an issue for employees as underpayment is. On the other hand, management becomes satisfied by profit maximization and minimum profit sharing. This is because goal of every company is to maximize the shareholder’s return which is the ultimate net income of the company to be distributed among all the members of the firm. So, the ultimate goal is to keep shareholders happy and give them the maximum profits through profitable earning. This conflict of self-interest in employees and the management of the company is what bring dis-satisfaction between both the parties. So, is order to make sure that both parties feel satisfied through their profit maximization technique, there is a need of designing a bonus package which is based on sale of the individual rather than total sales of the company. When the company puts bonus based on each customer whom the employees brings, the employee will try to earn more by bringing more people in buying the product/service. Thus the employees’ self-interest will increase towards the earnings. At the same time management will not have to share their profits with the employees rather they will pay employees based on their actual and individual performance. CASE 4 (a) Capital budgeting is defined as the process by which firms budget their capital by administering and controlling their investment opportunities and looking forwards towards the fixed assets. In addition, evaluation of inflows and outflows is done in order to get good idea of how and where is the firm moving in their process of costs and where can potential problems occur. Capital budgeting helps in identifying and hence allocating the resources to the right place and investing the best in management and most appropriately resourcing the company’s decisions. Two decisions are made by capital budgeting one is the financial decision and other is the investment decision. The company JB HI Fi limited uses capital budgeting by designing effective strategies to conduct their operations. The company’s financial reports show the use of financial gearing ratios in order to take the investment decisions and check the feasibility of decisions taken by the company. Also the company has been using payback period method and IRR in order to do the feasibility check and capital budgeting through which they have ensured making long term and short term decisions. (b) Capital budgeting can be done through any one of these four techniques each one having its own implications as well as challenges for the management: Net present value Internal rate of return Discounted cash flow Payback period The purpose of every budgeting technique is to provide the business with decision regarding the project which maximizes shareholder’s return and minimizes the costs of the firm. The technique which gives the most appropriate picture of the project’s profitability is used by management. Basic aim is to know whether the benefits from a particular project are enough to pay back for the cost of the asset, cost of investment and the interest of the investment. Payback method will not be recommended for the company as it does not incorporate the principle of time value of money. Although it is being used by many companies because of the convenience but still I will not recommend it to the management. Net present value is also a very good technique but it assumes that the entire amount would be re-invested in the business which is not true in real life hence I will not prefer this. Internal rate of return is the rate of return at which investor will earn on the investment made. In other words it is the rate of return which an investor expects from his investment in the project. Although this method is very good but it is based on hit and trial method which questions the reliability of the method. Modified internal rate of return is the technique which I will recommend to the company because this method covers the challenges of IRR and NPV technique. The analyst is able to make a choice of the rate he/she uses for the cash inflows and for the remaining life of the project. So, I prefer that the company uses this technique for capital budgeting. This method will make give accurate and perfectly forecasted capital budgeting with minimum chance of error. © There are two basic methods by which any firm finances its operations. One is the equity portion and issuing shares while second is the debt which the company takes either from banks or any other third party. Both the modes of financing have their own benefits as well as risks. Debt financing is very popular method and usually companies are based on 60-70% debt because of the ease with which they get debt and not sharing of ownership among the debt holders. But at the same time, debt and interest payments are the most important threat to any firms in cases of losses the firm can go vulnerable to their debt holders. At the same time, equity financing is very attractive because of no interest payment and no restriction of the return on invested amount. But at the same time, shareholders are the partners in the company as every shareholder gets ownership in the company. This increases the control of third parties thus leading to more conflicts in the company while decreasing the profits. So, keeping a balance between the challenges and the benefits of each mode of financing firms choose their mode of financing. The company finances its projects through issuance of equity as well as debt. This has been shown in the balance sheet and the statement of cash flows of the firm. The firm issues new shares in order to get investment from their shareholders. The amount which shareholders contribute is invested in new projects. At the same time, the firm takes loans in big amount from banks in order to finance their operations. The firm relies more on debt financing rather than equity financing thus having higher proportion of debt compared to equity in their annual reports. (d) Through the capital budgeting of the 12 months it can be seen that the firm has invested heavily in new projects. However, for the year 2012, the firm was able to have a very little cash inflow comparatively because of the high amount of outflow which was done to finance the investments and the earlier borrowings of the company. The firm had very high amount in repayments of their borrowings, dividend payments and the payments for the purchase of land and equipment. Thus for the 12 months, inflow was very less compared to the outflows which gave a few digit increase to the cash balance compared to previous year. However, despite of the high amount of repayments the firm had been able to maintain positive cash at the end of the year which is a good indication as it shows that the product’s earning are enough to cover its costs. However, the firm should be very careful in borrowing in future because of the high debt ratio and payments which they have to do on their debt. Thus the firm should try to do debt financing in future only if they have no other payment to be made in the following year otherwise they can be in trouble. Read More