Net Present Value Method - Essay Example

ACC3015 Assignment: Case Study ACC3015 Case Study Question a) i. Projected Cash flows ii. Cash flows of Alpha: Depreciation=100,000-10,000 = 18,000 5 Duration 　 Cash inflow/outflow (£) Disposal proceeds £ Depreciation (pounds) Cash Flows (£) Cumulative cash flows (£) Immediately -100,000 0 0 -100,000 -100,000 1 years’ time 15,000 0 18,000 33,000 -67,000 2 years’ time 18,000 0 18,000 36,000 -31,000 3 years’ time 20,000 0 18,000 38,000 7,000 4 years’ time 32,000 0 18,000 50,000 57,000 5 years’ time 18,000 10,000 18,000 46,000 103,000 6 years’ time 2,000 0 0 2,000 105,000 iii. Cash flows of Beta: 　Duration Cash inflow/outflow (£) Depreciation (£) Cash Flows (£) Cumulative cash flows (£) Immediately -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 Payback period Payback period of Alpha =2 years + (31/38) = 2 31/38 years Payback period of Beta = 3 year + (5/35) = 3.14 years Accounting Rate of Return (ARR) ARR of Alpha: Average annual operating profit before depreciation over the six years is = 33,000+36,000+38,000+50,000+46,000+2,000)/6=£ (£34,200 The annual depreciation charge will be = (100,000 – 10,000)/5 = £18,000 Therefore, the average annual operating profit after depreciation is £16,200 (that is £34,200 - £18,000). Average investment = (£100,000 + £10,000)/2 = £55,000 Therefore, ARR = (£16,200/£55,000)*100% = 29.4%. ARR of Beta: Average annual operating profit before depreciation over the six years is £28,800 (that is £000(50+55-20+35+28+25)/6). The annual depreciation charge will be £27,500 (that is £ (90,000 – 0 + 75,000 - 0)/6). Therefore, the average annual operating profit after depreciation is £1,300 (that is £28,800 - £27,500). Average investment = (£90,000 + £75,000)/2 = £82,500 Therefore, ARR = (£1,300/£82,500)*100% = 1.6%. NPV of project Alpha: Duration Cash flows (£) Discount factor (14%) Present value (£) Immediately -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 25,650 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: Duration Cash flows (£) Discount factor (14%) Present value (£) Immediately -90,000 1 -90,000 Year 1 50,000 0.877 43,850 Year 2 55,000 0.769 42,295 Year 3 -20,000 0.675 -13,500 Year 4 35,000 0.592 20,720 Year 5 28,000 0.519 14,532 Year 6 25,000 0.456 11,400 NPV 29.297 iv. Payback period v. Accounting Rate of Return vi. Net present value (b) Based on your calculations in (a) above, it is advisable that Alpha project would be the right choice for consideration. It yields the highest net present value. NPV always give a better choice since it does take care of time of investment. It does also allocate revenue to the dates they were realized as well as going in line with the owner’s main goal of profit maximization. For this reasons it gives the best indicator for choosing what project to adopt by going for the highest option. Here the project that yields highest NPV is Alpha. We also need to look at the cash flows since it gives us the project that will ultimately have some money at the end of the project time. The project with the highest cumulative of cash flows should be chosen. In this case, Alpha is this project. The accounting rate of return also tells us the project that will have more or less profits at the end of the period. The project that has less ARR will have less profits while the project with more ARR will have more profits. From the calculations, Alpha has the highest ARR, therefore, it will yield the highest profits. It should therefore be preferred. Lastly, by looking at the payback period, we need to choose the project with the shortest period. Payback period indicates the time that the project will take before it repays its initial cost of initiation. The project that meets this condition earlier is more preferred as it enables the owners to begin enjoying the profits earlier. Alpha has the shortest period, hence it should be chosen. (c) Discussion Accounting Rate of Return It is a method of evaluating investment by taking the average accounting operating profit that the investment can possibly make and dividing with the average investment made over the life of the project. It expresses this as a percentage. This method has a weakness of not being keen on time observation as it does not consider when revenue or losses are made (Elmmendor, 1993). It also does pay much attention to accounting profit instead of the absolute profit realized from a particular project. The bigger the value or ARR, the better the choice for any competing projects subject to these projects not exceeding the projected time, hence ignoring time value of money The method is easy to manipulate but it ignores uncertainty of accounting profits. However, it does have the advantage of relating profit to the amount of investment made as well as giving its answers in terms of percentages which is a preference of some managers. Some of the advantages for using this method is the fact that it is easy to use when carrying out comparison on projects. It also has a flexible time frame to cover any period that the investor so wishes. One reason for not liking this method is that it does not consider the terminal project amount. This sometimes is a good amount that may be used in gauging a good project. ARR = Average annual operating profit*100 Average investment to earn that profit Net Present Value Method This is the best method of all the other methods as it takes care of timing of the cash flows, all the relevant cash flows, as well as the major objective of the organization. The higher value is preferred to a lower percentage for competing projects. It considers the time value of an investment. A negative NPV should be abolished while a positive one should be accepted. Mathematically, it can be expressed as; 0 Where Ct is the cash flow, K is the opportunity cost of capital, Io is the initial cash outflow and n is the useful life of the project This method is usually liked as it utilizes the cash flows of a project in its determination. In this case, both the cash flows that come before and after the project’s lifetime is considered. However, due to the many complex calculations involved, the method is very hard and difficult to use. Payback Period This generally looks at the time when the cash flows will break even with the initial investment. It requires managers of a business to select a project with the shortest period as this will repay the initial investment faster. This though can vary with businesses. It does point to undertaking only projects that yield income faster than the rest without regard for the final profit of the project in the long-run (Grinyer, 2003). Cash flows are arranged in order of how they were realized. Their cumulative is then found and the point where the cumulative is zero is the payback period for that project. This method is preferred for its advantages including the fact that it is easy to calculate and interpret. The method also helps in identifying projects that are able to yield returns faster within a short period. On the other hand, this method does not cater for the cash flows after the payback period. Some projects may realize positive cash flows later, but for a long period of time. Internal Rate of Return It is the discount rate in the capital budgeting that equates the Net Present Value to zero. Generally, the higher the IRR, the more preferred the project is usually. The method, therefore ranks various prospective projects in order of their IRRs. The one with the highest IRR is normally picked over the others. This method is very easy to calculate and interpret. It also consider the time value for money. However, it ignores the project size, future costs as well as the reinvestment costs of the project. Question 2 a) Calculation of the ratios 1 1. Return on capital employed Roce = operating profit×100 Share capital + reserves +noncurrent liabilities Since we don’t have reserves, we’ll use the liabilities Benjamin = 10,000 = 23.8% 42,000 Peters = 15,000 = 34.1% 44,000 2. Gross profit margin (Revenue –COGS) Revenue Benjamin = (80,000 – 60,000) = 25% 80,000 Peter = (120,000 – 96,000) = 20% 120,000 3 Operating Profit Margin = Operating Income Net Sales Benjamin = 10,000 = 12.5% 80,000 Peters = 15,000= 12.5% 120,000 4 Acid Test Ratio = cash and cash equivalents Current liabilities Benjamin = 45,000-15,000/5,000 = 6 Peters = 40,000-17,500/10,000= 2.25 5 Inventory days = Ending Inventory ×365 Cost of Goods Sold For Benjamin = 15,000 = 91.3days (60,000/365) For Peters = 17,500 = 66.5 days (96,000/365) 6 Trade Receivable Days = Average Gross Receivables×365 Annual Net Sales) Trade Receivable Days for Benjamin = 25,000×365÷ 60,000 = 114 days TRD for Peters = 20,000 ÷ (120,000/365) = 60.83 7 Trade Payable Days = Ending Accounts Payable×3665/ credit Purchases Benjamin = 5,000×365 ÷ 42,000 = 43.45 days Peters = 3,650,000 ÷ 44,000=82.02 A report on the result of the analysis of the investment ratios Different financial ratios do represent different information. However, it should be noted that for a wiser decision to be made, more than two ratios should be considered since one ration may not be conclusive. Profitability These ratios are used to give clues on the level of success achieved by a business in maximizing shareholders wealth/profits. They use sales revenues, profits revenues, overheads. Under profitability ratios, we have the following; Return on Capital Employed-this relates the relationship between the operating profit generated during some period and the average long-term capital invested in the business. The bigger the ratio the better as it shows that the operating profit is bigger. For this case, Peter’s project is better as it gives a higher percentage. Operating Profit Margin-again this ratio shows how much profit is attributable to a particular quantity of sales made. The bigger the percentage the better for any business as it will show that more profits are realized just from a small sale volume. For this case, assuming they deal in the same business line, Benjamin will be a better choice for it has a higher operating profit margin than Peters. Gross Profit Margin-this relates gross profit of the business to the sales revenue generated during the same period. This ratio should be relatively bigger as a small ratio shows that cost of sale was larger, something not desirable. In this case, Benjamin is better at 25% compared to Peters at 20%. Liquidity These ratios show the ability of the business to meet its short-term financial obligations. For this report we will only use Acid-test ratio to evaluate the liquidity of the businesses. Acid Test ratio- it shows how much of the current liabilities are covered by the current assets excluding inventories. For this case, both of them have higher ratios meaning they are having funds tied up in cash and hence not being used productively. However, the higher this ratio is, the more efficient the business is in meeting its financial obligations. Benjamin has an acid-test ratio of 9 while Peters has only 4. NENE should, therefore, choose Benjamin Limited. Working Capital Management Inventory days- a short inventory turnover period is preferred for a business since longer times come with costs associated with storage costs of inventories. For this case, 66.5 days for Peters will be preferable to Benjamin. Trade receivable days-a shorter time is preferred to a long time as the latter would mean some funds are tied up instead of being used in productive activities in the business. For this case, 60.83 days for Peters will make Peters Limited a better investment than Benjamin with 114 days. Trade payable days. – This measures how long the business takes to pay its suppliers or creditors for their services. A longer period may be good for business in terms of funding of the business but this may lead to loosing of the goodwill of the creditors. The business, therefore, has to weigh between the two, which is more important at that particular time. In this case, Benjamin has a shorter period of 43 days while Peters has a longer period of 82 days. Peters’ suppliers will allow him enough time to invest in the business as the money stays longer in the business. (b) Limitation of using Ratios Relying too heavily on ratios have various shortfalls including the fact that window dressing can be used to conceal vital information, hence, leading to false reporting. This is used especially by companies doing really bad with their financials and so to attract investors, they report what actually is not happening (Gold & Forgatry, 1995). Secondly, a financial ratio can never be an end by itself. Normally, one can’t decide based on the outcome of one ratio. More than one ratio must be employed to arrive at the correct conclusion. Ratios use outdated information; basically historical information may not reflect the correct position of the business in the future or presently yet this is what investment ratios rely on. Finally, ratios are not definite in the sense that each and every company has its method of accounting, hence, lack of uniformity in the way data is reported. The same thing may influence judgements that are made from the use of data from such companies. Question 3: a) Costing i) Traditional Costing Method Overhead absorption rate (OAR) = £4,410,000/ (0.5 x 20000 + 1000 + 10000) =210 pounds Calculating 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% 15% 45% 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% 6% 47% 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% 18% 40% 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 b) Difference between Activity Based Costing and Traditional Costing Method It should be clear to the management that traditional costing method uses the volume of a cost driver: a factor that causes costs to be incurred (Pierce & Brown, 2006) to assign manufacturing overhead, while activity-based costing uses the activities required to produce an item in allocating the manufacturing cost (Kareem, et al., 2011). On the other hand, the cost will rely on the activities used by the cost objects in the Activity-based system. The last important point that the management needs to know is that, ABC method is complicated but more accurate to use than the traditional costing method. Therefore, my recommendation to the NENE Limited is that, for more accurate costing results, there is a need to train its members on ABC and adopts it since it has more accurate results though difficult to calculate. Conclusion Financial information can guide investors into knowing issues to do with project selection as well as production methods to use. The report will help the management of NENE Limited to make an informed decision, right from choosing project Alpha through Benjamin Limited and to using ABC costing method. Some of the methods used above, such as ratio analysis, have various limitations when making investment decisions and care should therefore be taken to avoid rushing through with any decision. 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