Strategic Management Accounting: Concepts, Processes, and Issues - Assignment Example

STRATEGIC MANAGEMENT ACCOUNTING: ASSIGNMENT Part A Introduction Firms need to assess the viability of their projects before deciding on whether to invest their resources or not. This assessment of viability involves use of capital budgeting techniques. In this case, we will examine the financial viability of a replacement proposal of Top Building Construction Ltd. Background Information Top Building Construction Ltd is well established company in the construction industry mainly focusing on building large industrial buildings, as well as offering maintenance services. This company has vast experience of more than 30 years, currently the organization has about 300 employees and £ 30 million turn over. The company has been able to maintain a competitive edge through increased innovative, good corporate image and technological advancement. In this organization, decision making can be characterized as participatory where all the management is employed in decision making process. Problems facing the organization One problem evident in this case is the rigidity of the organization to maintain those building that they have. The second problem is presence of management teams that does not have long-range plans, also the management team is not dynamic, i. e., the majority of the management impedes change in the organization. The third problem observed is the maintenance of book accounts in other financial statement of the company. The director of the company is inexperienced although she has a degree, but there is the traditional necessity to have an influential figure to head the organization. Part B Determination whether to replace the machine or not In order to determine whether to replace the existing machine with the new mechanism, we need to calculate the Net Present value relative to the old machine. In order to achieve this objective we will follow the following steps: Step 1 : Determination of the incremental cost outlay associated with the replacement Purchase price of the new machine 345000 Add: installation cost - Less: market value of the old machine (20000) Tax recapture Market value of the old machine 20000 Less: the net book value of the Old machine (10981) Gain or loss on disposal 9, 091 Tax recapture = gain or loss on disposal x tax rate = 9091 x35 % (3181.85) 321818.15 Step 2: Determination of the incremental depreciation Depreciation of the new machine (345000-30000)25% 78750 Less: Depreciation of the old machine (195000-5000)25% (47500) 312 500 Step 3: determination of the incremental salvage value or the terminal value. Salvage value (scrap value) of the new machine 30000 Less: Salvage value (scrap value) of the old machine (5000) 25000 Step 4 : determination of incremental maintenance cost Maintenance costs of the new machine 50000 Less: Maintenance cost of the old machine (40000) 10000 Step 5: determination of the incremental savings and cash flows Expected cost in case of breakdown of the old machine 25000 (savings in the case of new machines) Pre-tax profits of the company could attracting due to the use of the new machine W2 30000 55000 Step 6: Determination of the Net present value using the cost of capital of the company as 15% Depreciation tax shield (tax savings) =incremental depreciation determined in step 2 x tax rate 10937.50 Less: incremental cost (determined in step 4) (10000) Add: incremental savings and cash flows 55000 Annual net cash flows before tax 55937.5 Less taxes (35% x 31437.5) 19578.125 Annual cash flow after tax 36359.375 PVIFA 10 years @ 15% 5.0188 Present value of cash inflows 182,408.4313 Add: The terminal benefits (0.2472 x 25000) 6180 Total present value of total cash inflow 188,588.4313 Less: incremental cost determined at step one (321818.15) NPV (133 229.7187) Since the Net present value of the replacement is negative, the replacement process should not be undertaken whatsoever according to the Net Present criterion. The Payback Period Method Year Annual cash flows Cumulative casflows 1 36359.375 36359.375 2 36359.375 72718.75 3 36359.375 109078.125 4 36359.375 145437.5 5 36359.375 181, 796.875 6 36359.375 218 156.25 7 36359.375 254515.625 8 36359.375 290 9875 9 36359.375 327 234.375 10 61359.375 388593.75 The payback period of the AL II is 9 + 1765.625 = 9.05 years 388593.75 The decision criteria of the company are to select projects that have their payback period as five years and below. In the case of AL II, the payback period is 9.05 years, therefore, the replacement process should not be undertaken. The IRR Internal rate of return is the minimum rate of return that equates the total cash inflows to the initial cash outlay, such that the net present value is equal to zero (Shapiro, 2005). There are many formulas used in calculation of IRR, but the most popular one is IRR = lower rate of return + (higher rate of return – lower rate of return) positive NPV/ (positive NPV + negative NPV (absolute)) Assume a discount rate of 5% the NPV would be given as follows Total annual cash flow is Annual cash inflows x PVIFA 10 years @ 2% i. e, 8.9826 x36359.375 =326 601.7219 Terminal benefits 25000 x 0.8203= 20 508.7075 Present value cash inflows = 347 110.4294 Present value of cash outflow = (321818.15) NPV 25292.2794 Therefore IRR = 2% + (15%- 2%) 25292.2794/(25292.2794 +133 229.7187) = 4.0742% The IRR of the project is below the minimum required rate of return on company invested, therefore, under the IRR criterion the project should reject. This is because 4.0742 %< 15% My advice is to reject the project since the IRR is below the company cost capital. In addition to this, internal rate of return is one of the best criteria as it is considered to be a measure of marginal efficiency of the capital invested. Strategic Issues to be Considered by the Firm in the Replacement Proposal Availability of the funds to finance the replacement There is need to analyze the firm financial capacity toward financing the replacement proposal. If it is not financially capable in implementing the proposal, the firm should search from resources elsewhere. In this case, the firm may result in borrowing, thus, the firm should consider the cost of borrowing and covenants attached to such borrowed funds (Hoque, 2005). Effects of the new machine on environment conservation It is necessary to consider the level of environmental degradation occasioned by the implementation of the proposal. If the existing machines pollute the environment at higher rate, that increases chances of the company facing legal suits emanating from environment pollution, the company might consider undertaking the proposal. Effects of the replacement proposal on attractiveness of the firm Another strategic factor that needs to be analyzed is the image of the firm due to the adoption of the replacement proposal. It has been ascertained that acquisition of the new equipment will increases the attractiveness, thus, attracting more contracts, since the clients would like the machine to be more efficient and productive (Hoque, 2005). How the replacement will affect the technological capacity of the firm Acquisition of the new machine will enhances the technological capacity, thus, making the firm to appear to be innovative; this would offer the organization a competing edge among its rivals. Effects of the replacement proposal on employees There is a need to analyze the effects of new machine to the existing work force; the machine should increase the morale of the employees so as to increase the overall productivity of the firm. Another aspect that needs to be analyzed is whether the machine will result in replacing some workers after they were rendered redundant. Also there is a need to analyze whether the existing employees have right skills that would help in operating the machine (Smith, 2007). Government laws, policies and regulation The machine should conform to the laid down policy and rules and should be acquired in accordance to the laws prescribed by the governing authority. How the replacement proposal affect the flexibility of the organization. An analysis on whether the new machine would increase the organization flexibly also needs to be undertaken so as to capture the effects of the replacement that was not captured the capital budgeting (Shapiro, 2005). Part C Summary and Conclusion After appraising the replacement proposal using the Net present value where the NPV was less than zero, the payback period was ascertained to 9.05 years, the internal rate of return has been determined to 4.07% which is lower than the minimum required rate of return (15%). Under these criterions, the company should implement the replacement proposal since under the capital budgeting methods, the project was not desirable; thus, I would recommend the replacement proposal be rejected. In conclusion, apart from the capital budgeting techniques that the firm uses in assessing the viability of the project, it also needs to considered other strategic aspects that would be used in appraising the project for factors, such as environment conversation, that are not quantified in monetary terms. Bibliography Hoque, Z. (2005). Strategic Management Accounting: Concepts, Processes and Issues. Upper Saddle River: Pearson Prentice Hall. Shapiro, A. (2005). Capital budgeting and investment analysis. NewDelhi: Pearson/Prentice Hal. Smith, J. (2007). Handbook of Management Accounting. Oxford: Elsevier. Read More